Finance exam 3

Term structure of interest rates

-The yield curve, also known as the term structure of interest rates, describes the relationship between the yield on a security and its maturity -The shape of the yield curve, depending on the rate of inflation or deflation, the economy and monetary policies, can be upward sloping - which is the most common, downward sloping - when a significant slowdown in inflation is anticipated, flat, or humped - securities represented differ only in maturity, not other factors especially not risk - typically determined by yields on non-callable, risk free, highly liquid US treasury securities

Profitability Index

PI- The NPV of an investment, divided by its cost. PI is used to identify projects that will receive the best return associated with the amount of dollars invested by ranking the projects by PI PI rule is: accept the venture with the highest profitability index first; then accept ventures with lower and lower positive PI's until the projects expend the capital budget; do not accept projects with a negative PI.

Free cash flow to firm valuation approach

The discounted free cash flow to the firm valuation approach is a four-step process to value the stock of a company : Step 1: Forecast the company's Expected Cash Flow *use most likely assumptions regarding growth, net profit, income tax rate, etc * divide ECF into 2 time periods: expected return period (excess of cost of capital) and residual value period (after ERP, can't create extra cash flows) Step 2: Estimate its Weighted Average Cost of Capital *discounting rate used Step 3: Calculate the Enterprise Value of the Company *use WACC to discount ECF during ERP to get aggregate of corp's cash flows from profitable operations * calculate company residual value: divide company net operating profit after taxes at end of ERP by WACC. * discount future value back to today at discount rate equal to WACC corporate value = cf operations + residual value + ST assets Step 4: Calculate Intrinsic Stock Value *subtract value of company senior liabilities - debt/preferred stock from enterprise value to get value to common equity VCE = corporate value - debt - preferred - ST liabilities *divide value to common equity by shares outstanding to get per share intrinsic value *get most info off web

Fixed rate/fixed coupon bonds

interest paid every six months. most common type issued and traded in US. fixed over life of the bond and payments don't change.

Types of derivative securities

Types of derivative securities *Equity and Debt Components: -Embedded with the characteristics of a simple stock or bond. -The bond component can be fixed-rate, zero-coupon, or amortizing. *Option or price insurance components: -Interest rate floors and caps, call and put options. -Zero or positive values are associated with these components for the owner of the option. -Zero or negative values are associated with these components for the writer of the option. *Hedging or price-fixing components: - Forward, futures contracts, interest rate and currency swap - The value of these components may be positive or negative, depending on movements and shifts in yields, currency levels, or spot prices. - The relative value at the time of issuance of the derivative security is zero. - Generally have little upfront cost and are the most efficient type of hedging contract.

Firm Specific Risk

Unsystematic or firm specific risk—risk that affects the return of that firm or industry only. On average, the firm specific risks average out to be zero, if an investor holds a diversified portfolio. Finance theory assumes that investors are rational and own diversified portfolios.

Hedge Fund Fundamentals

"2 and 20 Fee Structure" *2% charged on assets under management *20% charged on performance *Hedge fund managers are rewarded for good performance Fees are much higher than mutual funds, which usually charge around 1% Absolute Return Strategy Generate a Return Regardless of Market Return Carried Interest Tax Issue Hedge funds profits are taxed as capital Gains (15%) High Water Mark If a fund suffers losses, managers don't get paid performance fees until the losses are recovered

Percentage gain to break even

% gain required to make an investment whole after suffering a loss. 1/(100%-% drop)

Taxable equivalent yield

(r/1-T)

Credit Unions

* 10,000 in US * FI that services banking needs of members and is similar to specialized S&L * common bond * sell credit shares, similar to savings accounts, and invest monies in mortgages made primarily to members of credit union * like mutual savings banks, organized as mutual organizations and owned by depositors. *customers receive shares when deposits are made and earn dividends on funds. * only allow members of particular orgs, occupation, employer or geographic area. *non profit and exempt from fed income taxation, thus have lower loan rates and pay dividend rates on shares * principal assets = loans to member *mostly relatively small loans * established in 1910, # of members has increased steadily * many get help of employer, which might provide office space/amenities to support it

Random walk hypothesis

* A Random Walk is a path a variable takes where the future direction of the path (up or down) can't be predicted solely on the basis of past movements. *If stock markets are efficient, share prices react immediately to news. we cannot predict the next news event either *in short run: successive price changes = independent of each other and the best estimate of tomorrow's stock price is today's stock price *There is no predictable trend implied by a gradual market reaction. In an efficient market, share price changes are random

Repealing Glass Steagall - Financial Services Modernization Act

* GSA = most important regulation passed in 1933 * GSA forced separation of traditional commercial banking and investment banking activities * importance has been watered down by financial service deregulation and innovation by FS firms * 1999: Congress passes Financial Services Modernization Act. - eliminates Depression-era firewalls b/w banks, securities firms and insurance firms imposed by GSA. now cross ownership is possible, and all services can be offered by one institution now - applies domestically and to foreign companies doing US business

Residual value of company

* Once a company loses its competitive advantage the stock price of the company still grows in value, but its growth does not exceed its risk-adjusted market expectation of the investors. *At that point in time, the after-tax earnings of the company can be treated and valued as what is known as a cash flow perpetuity—equal to the company's net operating profit after tax divided by its WACC. This discounted value is called the company's residual value. * Residual value is very important—it generally represents 60% to 90% of the company's stock value.

bulge bracket investment banks

* banks that control majority of transactions in the financial markets * being in this category depends on size, presence in specific areas, reputation and distribution network * serve fortune 100s,international governments, and participate in world's largest deals * not set in stone

Finance companies

* began in early 20th century and used to finance loans to individuals/businesses that purchase products manufactured by an entity w/ relationship to finance company *little regulation compared to depository FIs *make loans to investors w/ less than stellar credit ratings * higher risk loans, so finance co charges much higher interest rate than rates on bank loans. * bigger chance of default * levels of interest rates allowed to be charged based on usury rates permitted by various states, dependent on size type and maturity of loan *borrow in ST variable rate funds in commercial paper mkt and use proceeds to make LT fixed rate loans to borrowers. accept risk associated w/ default of borrowers and liquidity risk of constantly rolling over their liabilities and owning very illiquid assets funded from those liabilities

characterization of cash flows

* bond: future cash flows are payments of periodic interest + repayment of principal at maturity * mortgage: monthly payments consist of both pmt of interest on mortgage and repayment of portion of principal (property should be worth more than value of the loan in the eyes of financial institution) * stock: FCFs = payment of dividends if any and appreciation (capital gains) or depreciation (capital losses) associated with movement in stock price once value is estimated, compare it to asset price to determine which assets are undervalued or overvalued, then which to buy sell or hold

convertible bonds

* bonds that are issued by a corporation that usually pay fixed rate of interest and after certain period of time, can be converted into a fixed number of shares of the issuing corporation *valuable option, attractive to investors * lower interest rates *more difficult to value as a financial asset

insurance companies

* contractual intermediaries that pool risk and spread costs over as many entites/individuals as possible to minimize effect of losses suffered by any individual event/occurrence. * premium charged for assumption of risk -> amount usually based on actuarial probabilities of an adverse event that triggers a claim occurring * premiums received are invested until needed to pay claims * if events requiring payments are consistent w/ historical avg, and there are a large number of entities, insurance companies profit. overexposure to certain industries, geographic regions or catastrophic events can require insurance companies to pay significant claims all the time * primary revenues are premiums/income from investments that insurance companies earn by investing premium income * primary expenses come from claims/benefits. most insurance companies specialize in one insurance

FDIC

* created by Glass Steagall Act of 1933 *insurance against bank failures, required all national banks/members of Fed Reserve system to purchase federal insurance on deposits * non members could purchase FDIC insurance and most did * deposit insurance = guarantee under which depositors of a bank are paid off on first 250K that it has on deposit in a bank that fails * if bank fails, FDIC uses: - payoff method: pays depositors up to 250K on their accounts. for funds over amount, FDIC and depositors join other creditors of bank and are paid their proportionate share of carcass of estate upon recovery of all assets from liquidation - purchase and assumption method: involves FDIC finding willing merger partner to take over all investment bank deposits so no depositor suffers a loss *regulates almost 6K state chartered banks

Mutual savings banks

* depositors of bank = owners * no stock issued - depositors own percentage of bank in proportion to amount of funds they have there. *located mostly in northeast US * more conservative b/c of mutual ownership and thus experience less failure than S&L industry * asset base =mortgages,private placements and corporate loans. more diverse than asset base of S&L *800 in US, mostly state chartered * can insure deposits with FDIC or state agencies through which they're chartered.

DCF steps & decision rule

* develop set of future cash flows expected to be recieved * estimate interest rate to discount ECFs * multiply ECFs by appropriate discount factors and add them to calculate asset value Decision Rule: If the value of an asset is greater than its price—Buy it! If the value is less than its price—Sell it!

gross spread

* difference in yield b/w primary securities that FI owns and secondary securities/services that FI sells * measure of earnings on activities * used to pay cost of operations, cover default on primary securities, and generates profit for owners and shareholders

Diversification Intermediation and Default Risk

* diversification can be hard to achieve with limited money and investment opportunities *when FI pools funds of many investors, FI can take advantage of economies of scale and specialized expertise in analyzing default risk * FI can hold diversified portfolio of loans/assets, and allows investors/depositors in FI to share in diversification benefits * lower risk allows investors to accept lower returns on invested assets and allows lower rates on loans

stock value and dividend policy

*The dividend policy of the firm should not affect the current value of a stock. (dividend irrelevance hypothesis) *However, the expected future value of a stock is greatly affected by dividend policy. *When a company does not pay dividends and reinvests its earnings in projects, the investors receive no current dividend but instead receive an increase in stock price.

McCarran-Ferguson Act of 1945

* exempts insurance companies from federal regulation so state regulators perform most regulation * must follow regulations of each state in which it does business *NY = most stringent state with very large mkt for product.if a company does business here and abides by regulations, it usually qualifies in other states * to insure that agents/brokers have proper training/knowledge about products they're selling, agents and brokers MUST be licensed by in state regulator

Stock Brokerage Firms

* firms that buy and sell securities on behalf of clients * can be full service, discount or online * full service: complete financial analysis, investment planning, retirement planning, provide their own research/forecasts on huge array of securities and mkt conditions, etc. these firms are members of all major exchanges. fees can be very high * discount: basic and fewer investment services at much lower fees bc their costs are much lower. may be more limited in research and product availability *Etrade: investors can purchase and trade via online accounts. trades made over phone or via internet. the fewer people involved, the lower the comission rates. rates are equal to or even lower than those of deep discount firms

institutional banking services

* lends and borrows w/ other financial corporations, non-financial corps, and gov't agencies *mostly loans/CF mgmt of deposits. * finance commercial real estate, arrange leases, and factor accts receivables * handle large amounts of cash, so the size of accts are huge

life/property/casualty insurance

* life insurance: protection against premature death, and sell special retirement benefit (single premium deferred annuities) - liabilities = reserves for payments of death benefits/contractually assured retirement streams. which are fairly predictable - assets = corporate bonds, equities and mortgages - low tax rates * property/casualty companies sell protection on property and health through auto, fire, health and other types of insurance. - principal liabilities: reserves for policy payments - payments are often caused by catastrophic events * less predictable payment streams - heavily taxed, buy tax-advantaged investments like municipal bonds, equities and corporate bonds

Federal Open Market Committee

* meets 8 times a year * makes decisions based on level of money supply/ST interest rates * conduct open market operations: fed is either buying securities in mkt and adding to money supply (reduce interest rates) or selling securities to decrease money supply (increase interest rates) *set reserve requirements, determine discount rate of Fed Reserve loans

functions of financial intermediaries

* middlemen to transfer assets b/w one group of clients (savers) into liabilities of another group (borrowers) * issuers of secondary securities when they transform financial assets of one group (money from depositiors) into liabilities of financial institution * create primary securities for customers (mortgage loans, credit card loans, car loans) and may sell those financial assets to other mkt participants in primary mkt *provide investment advice/service and portfolio mgmt services for a fee to clients

types of mutual funds

* money MF: invest in ST, highly mktable security like US treasury bill. invest in high quality debt securities and have short maturity/lower risk - regulated to invest in certain high quality, ST investments - losses are rare * bond MF: invest in bonds issued by US treasury, corporations, or other economic entities. risk associated between money and stock funds. high degree of credit risk * stocks MFL invest in stocks issued by corps - more risk,but offer highest returns, have performed better, rise and fall quickly in ST many types of funds within these 3 general

Pension funds

* most impt contractual financial intermediary * 18% of intermediated assets in US and mkt share is growing as life expectancy increases * as employers/employees contribute money, money is invested and grows on tax free basis until retirement when they begin to receive payments under pension program (no taxes paid until received) * fund sponsors = corporate employers, workers' unions, state/local municipal entities * contractually assured stream of retirement benefits called pension plans. options on types of payment streams - defined benefit plan: sponsor agrees to pay predetermined amt of money, usually on monthly basis to pensioner or his/her beneficiary. guarantees certain amt on retirement, and is responsible for payment of a stream of pmts. guaranty performance of investments associated with fund - defined contribution plan: sponsor makes periodic contribution into employer acct of pension fund which doesnt guaranty performance of investments or stream of payments worker will receive * invest in domestic/foreign equities and bonds and alternative investments like hedge funds. * predictable pay streams * focus is LT investment performance and liquidity of assets ≠ major concern

global banking services

* needed by companies with international distribution who have to hold/exchange foreign currencies to trade in international mktplace * dominate foreign currency transactions * scale/network to exchange significant amounts immediately

Online banking and investing

* normal banking services * can pay higher interest rates * smaller fixed overhead costs/lower transaction costs *newest/best encryption software/firewall hardware * dealt serious competitive challenge to traditional firms

state securities regulation

* often discovers illegal activities of FI and will institute civil/criminal proceedings * often works with SEC to administer and prosecute financial institutions that have violated fed/state security laws

Federal Reserve System

* oversees domestic monetary policy * most important central bank in the world.there are 12 Roles: * issues new currency/withdraw damaged currency *clear checks/administer payments system *approve/make discount loans to commercial banks in district *examine bank holding companies/state chartered member banks *collect info/data relating to local economic and business conditions and repping interests of districts in fed reserve system * all national banks chartered by Office of Comptroller of the Currency must be part of FR *state and regulatory can join but aren't required * all depository institutions doing business in US must keep deposits at FR in reserves with size depending on size/type of deposit performed by DI - don't earn interest

Role of Financial Institutions

* provide important services to the economy of US and world *indirect finance = process of funds moving from investors through financial intermediaries to borrowers * institutions/mkts exist so that excess moneys can be transferred cheaply and efficiently to businesses/gov'ts/individuals/other entities w/ profitable investment opportunities + shortage of funds

State banking, insurance and securities regulation

* purpose of gov't regulation of FIs is to protect clients, depositors or claim holders from losses due to improper mgmt/insolvency of FI * to protect constitutents from fraud/improper practice, most states have insurance, banking and security regulators and commissions responsible to oversee financial companies operating in a state. regulators act with fed to investigate/prosecute unfair activity * state banking regulators work with FDIC to examine state chartered banks with FDIC insurance. solely responsible for 500 state chartered banks w/o insurance

Diversification: costless way to reduce risk

* spread wealth equally among different asset classes and investments *invest in group of assets that provides highest return possible for given level of risk *As long as the returns of assets are not perfectly correlated, diversification acts to reduce risk *Correlation -Measures the degree to which the movement of variables are related, and can range between -1.0 to 1.0 -Correlation of 1.0 means when one stock up 10%, the other stock also up 10% -Correlation of -1.0 means when one stock up 10%, the other stock down 10% *highly correlated assets offer less risk reduction from diversification than assets that are less correlated *thus, go with stocks from different industries *Diversification is easy to obtain in a portfolio *Achieving the highest return for certain level of risk is known as investing on the efficient frontier *Studies show that 20—25 stocks are sufficient to reduce risk

Theory of ECMs

* stock market is brutally efficient. current stock prices reflect all publicly available information, stock prices adjust and react completely, correctly and instantaneously to incorporate receipt of new info. *useless to analyze patterns of past stock prices and trading volume to forecast future prices (mkt technicians do this with technical analysis) * useless to analyze economy, industries and companies and study financial statements in an effort to find stocks that are undervalued or overvalued - research analysts do this with fundamental analysis many wall street people think this is just a theory that doesn't describe real life action of stock market. Acadamics disagree and point to studies supporting notion that stock market is efficient *some chinks DO exist in the armor EFFICIENTLY PROCESSES INFORMATION. PRICES OF SECURITIES FULLY REFLECT AVAILABLE INFO AND ARE BASED ON ACCURATE EVALUATION OF ALL AVAILABLE INFO. *if market is efficient in pricing stocks, ominous implications for investors. if there are no trends, then predictions are useless, and buying on good news won't be beneficial

Depository intermediaries

* such as commercial banks, savings, and loan associations, savings banks and credit unions, which take your deposits and issue highly liquid secondary securities (ie checking/savings accts). use your money to make business, mortgage and car loans and invest it in other illiquid primary securities and loans * most important type * commercial banks = largest, most important type of financial institutions; other Depository intermediaries are other depository FIs that compete with banks

Contractual intermediaries

* such as pension funds, life insurance companies and property/casualty insurance companies. common element is client base pays for contractually determined source of funds that are stable/predictable`

Intermediation and economies of scale in info and costs

* take advantage of EOS in search, info and transaction costs * search costs to find investors/investment alternatives = time consuming and considerable - FI can pool investment assets and provide necessary info (ie best price) at considerably lower cost than what would be available to individual investor

Personal banking

* to individual lenders/borrowers * accept deposits and pay interest on deposits, checking accts, credit card financing, mortgage loans, car loans, personal loans, school loans, installment loans *clearinghouse for transactions under which consumers purchase goods w/ non-cash instruments (credit cards, checks, debit cards). * target to individual consumers in need of banking intermediation to borrow, save and exchange

Value

* value: (stock, bond, mortgage, etc.) equals the present value of its expected cash flows, discounted (reduced) for their risk and timing. * Expected cash INflows are the most likely cash payments (dividends, interest, capital gain or loss) that you can expect (not hope) to receive. Expected cash OUTFflows are money you can expect to pay under debt owed *Discount: multiply a number by less than one. *Discount rate: a function of time of ECFs and risk associated with receiving cash: discount rate = f (time, risk). INCREASE for securities with greater default risk and DECREASE for securities with lower default risk. *Discount factor: a function of both time and the discount rate- [discount factor = f (time, discount rate)]. ex: if discount rate is 1.06 (6%) and 1 yr cash flow, divide 1 yr by 1.06 to get .9434. if ECF is 2 yrs, divide .9434 by 1.06, and keep going. it will decrease with increasing time to payment and decreases with incereasing discount rate *Present value (PV) of an investment is the sum of the expected cash flows multiplied by their respective discount factors

Financial Crisis of 2007-10

* wall street dies, victim of its own greed, arrogance and stupidity *JP morgan takes over Bear Stearns - orchestrated by US Treasury/Fed * 2 large mortgage lenders (Fannie Mae and Freddy Mac) put into conservatorship and placed under control of US Treasury *Private lenders such as IndyMac seized by FDIC *FDIC increases deposit insurance from 100K$ to 250K$ to prevent total banking panic * big killer: Lehman Brothers file for bankruptcy, causes chaos and panic * CEO of Merrill Lynch sells company to Bank of America (last chance to cut a deal) same night * markets cease to function, prices of stock/bonds plummet, feared there would be a run of $3 trillion money mkt industry. Treasury steps in to guarantee money mkt funds * Goldman Sachs and Morgan Stanley are now the only 2 large investment banks left; stock prices plummet, rumors spread of their pending bankruptcy - Fed says: convert to commercial banks and receive FDIC insurance. both, out of fear, apply to do so * in span of 9 days, 4 large Wall street firms ceased to exist! they had all been buying risky, illiquid assets using too much debt. value of these assets dropped with markets, their equity was dropping! debt had exceeded equity * after Bear Stearns, Treasury and Fed start pumping money into economy, shoring up credit markets and introducing new credit facilities * Emergency Economic Stabilization Act of '08, US Treasury: bailout. authorized Treasury to create 700 billion dollar Troubled Asset relief Program (TARP) to purchase distressed mortgage backed assets/make capital injections * treasury pumps money into and buys preferred stock in 9 biggest commercial banks * By end of october, investors had lost $11 trillion+

Commercial banks

* ~7,000 in US which make up nations most important type of FI - depository intermediaries - principal role in payments system - crucial to flow of money in economy of US - provide checking/savings accts and make loans to businesses, consumers, gov'ts and agencies (over 6 trillion annually) - before 1863, all banks were state chartered/regulated by banking commission of state - National Banking Act of 1863 created national banks which were federally chartered and supervised by a US Treasury department (office of Comptroller of the Currency) - today, there are both fed and state banks which create a dual system

bond yield equation

*A bond is valued by discounting bond's cash flows at the yield level that is required by securities of comparable maturity, risk, liquidity and call features. Hence, the computation of a required yield level is a function of all of these factors *The yield on a risky security can be represented by the yield on a comparable maturity risk-free security, plus a measure of the spread to Treasuries for default risk, plus a bond specific spread i.e. Bond Yield = Rf + Spread to Treas. + Bond Specific Spread

Liquidity Intermediation

*Ability to readily convert financial asset into cash (ie checking accounts = liquid, loans to businesses ≠ liquid) * offer individuals what they want - liquid financial assets - and use the funds provided by those assets to give businesses what they want - LT loan)

fundamental analysis

*According to Fundamental Analysis approach, the company's current and future operating and financial performance determine the value of the company's stock *The assumption underlying this approach is that a company's stock has a true or intrinsic value to which its price is anchored. When there is an price divergence, the price over time will gravitate to its intrinsic value. *To assess a company's prospects, fundamental analysts evaluate overall economic, industry and company data to estimate a stock's value * value is a function of revenue, growth, earnings, dividends, cash flows, profit margins, risk, interest rates, etc * basis for LT buy/sell decisions. if stock price is BELOW intrinsic value, BUY the stock; if above intrinsic value, SELL stock

Liquidity Preference Theory

*According to the liquidity preference theory most investors prefer to hold short-term maturity securities and hence in order to induce investors to hold bonds with longer maturities, the issuer must pay a higher interest rate as a liquidity premium *Thus under this theory, long-term rates are composed of expected short-term rates plus a liquidity premium which increases with time to maturity *This theory implies an upward-sloping yield curve even when investors expect that short-term rates will remain constant * if an investor wants a 2 year maturity bond, can purchase 3 year bond and sell after 2 years. this involves risk because investor doesn't know what price it can be sold for after 2 years * compensation for investors to accept risk in purchasing longer maturity securities where they would prefer shorter maturity securities. *premium = extra yield demanded by market to stretch maturity preference by specified number of years. increases with time to maturity *YIELD CURVE IS HIGHER THAN PURE EXPECTATIONS *investors are risk averse

Default risk and bond ratings

*All taxable fixed-rate debt that is issued or traded in the U.S. capital markets is priced at what is called a spread to Treasuries which is the measure of default risk on an asset-backed transaction or a specific company's debt *The interest rate, or yield, of all debt is vitally dependent on the risk-free rate associated with the comparable maturity U.S. Treasury debt . all other debt has a higher yield (effective interest cost) *This spread will change over time depending on economic conditions and the relative default risk associated with the specific debt security

value of a perpetuity

*An asset that has a stream of even cash flows that continue to infinity is known as a perpetuity *The value of a perpetuity is calculated by dividing the level annual cash flow associated with the perpetuity by the discounting rate: Value of a Perpetuity = Annual Cash Flow/Discounting Rate

Efficient capital markets

*Asset prices react very quickly to the receipt of new information. *New information is random. Can be good or bad. *Quick reaction of many market participants to new information tends to drive prices to their "correct" level. * all investments are properly priced and have 0 NPV, meaning cost/value = current price * market is efficient if return/risk characteristics of all investments lie on risk return line: undervalued = over risk/return line and overvalued if below risk return line * no investment is good or bad, each should be priced in a manner that its expected return is consistent with level of risk

Yield curve as predictor of ST rates

*Based on empirical evidence, the yield curve has been a particularly poor predictor of future short-term interest rates *However the rates implied by the pure expectations model of the yield curve is important because trading activity can effectively lock in the forward and zero-coupon rates that are implied in the yield curve, the yield discount rates can be used to value cash flows associated with bonds and valuation of derivatives * compared to simple forecasting model - assumption that ST rates will remain constant for the next observation period. *implied forward rates probably overestimate expected future ST results

Risk classification

*Beyond the corporate credit risk rating is the risk classification specific to a particular bond issue of the company *Senior debt is usually the most secure debt issued by a company. In the event of liquidation in bankruptcy, the most senior debt is paid first and whatever is leftover is distributed to the rest of the debt holders. not important to healthy firm *Subordinated debt is debt that follows senior debt in line for claims on cash flows and assets upon liquidation (more risky)

intro to stock valuation

*Common stock represents a pro-rata ownership interest in a corporation * stockholders have residual claim on corporate assets and are subject to limited liability (max amount that a shareholder can lose in event of corp failure is cost of shares) *The value of a stock depends on the firm's future profits or cash flows and the rate of return or required yield that is expected from the investment *Higher profits increase a stock's market value and lower profits decrease its value—a direct relationship * Higher interest rates decrease market value and lower yields and interest rates increase value—an inverse relationship. *A stock is valued in the same manner as any other financial asset—discount its expected cash flows at a risk-adjusted discount rate. *The range of future cash flows for a stock can be enormous. Cash flows can be higher or lower than expected. We make simplifying assumptions regarding the expected cash flows. *A corporation is a legal entity that has an infinite life and the valuation procedure must address the issue of valuing cash flows to infinity.

Corporate Bonds (taxable bonds)

*Corporations issue bonds to finance their long-term capital needs and to take advantage of tax deduction associated with the interest payments on debt (usually issued in stable industries) *Bonds are issued in the primary market through investment banking syndicate at a yield based on the spread to Treasuries that is required for an issue with the appropriate risk/bond rating, prepayment aspects and liquidity considerations. *secondary markets: some traded in bond section of stock market but majority are OTC among financial institutions/dealers that specialize in corporate bond trading

Modern Portfolio theory (MPT)

*Efficient capital markets is a cornerstone of MPT and is the belief that stock prices always reflect intrinsic value, and that any type of fundamental or technical analysis is already embedded in the stock price. *As such, MPT devotees tell investors not to bother to search for undervalued stocks but instead to pick a risk level that they can live with and diversify holdings among a portfolio of stocks. *However empirical evidence shows that there is value to careful stock selection. *believed by academics but not by investment professionals *when stock price is overvalued and exceeds intrinsic value by more than x% (investor picks), SELL it and replace with another stock that's undervalued by more than X% to benefit from diversification

Derivative Securities

*Financial instruments -Value derives from or is based on ~The value of a simple security or ~The level of an interest rate or ~Interest rate index or ~Stock market index *Delivery occurs sometimes many years into the future, and buyer or seller can initiate offsetting transactions, which enables it to close out position without requiring delivery of asset. Based on futures prices, which are influenced by commodities spot price and other things *Many securities have features embedded in them that make them derivative securities, such as callable bonds, and convertible bonds *Value Call Option = Value Callable Bond - Value Non-Callable Bond *Derivative securities often are more sensitive to price or yield changes, and sometimes are more leveraged *Attractive to hedgers *Can backfire for speculators

DCF valuation analysis

*In the DCF approach a stock's value is the sum of the expected cash flows of the company, discounted at an appropriate interest rate. * The most basic DCF approach is the dividend discount model (DDM), under which an analyst estimates future dividend growth and the required rate of return on the stock and discounts those expected dividends to arrive at a stock's value. *Other DCF approaches are the free cash flow to equity (FCFE) model (cash flow left over after payments for working capital, cap expenditures and interest/principal on debt and dividends on preferred stock and free cash flow to the firm (FCFF) model.

Interest rates and the economy

*Level and direction of interest rates have played a very important role in the valuation and pricing of securities in the financial markets and in whether an economy is going to grow of contract * Fed reserve = central bank and requires all commercial banks to have a 10% reserve on deposit with federal reserve. If there's no sufficient reserves, borrows funds in FF mkt and pay interest rate on borrowings *Fed funds: The interest rate at which depository instutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight. It is not (as the name might initially suggest) the rate at which the Fed lends to financial instutitions. * level and movement affect all other ST interest rates in US/most of the world * to expand, reduce the FF rate to encourage hiring, new facilities and new markets * to decrease expansion/possible inflation, increase target FF rate * stock and bond markets view lowering of rates favorably and rise significantly when surprise FF rate cut is announced. when rates rise the opposite occurs

mutual funds and investment companies

*MF = pool of money managed and invested by professional managers * raise money by selling shares to investors, and money is used to buy securities * most have redemption features -open-end: continuosly willing to sell/buy back features at net asset value per share or total value of investment holdings divided by # of MF shares out standing - closed end funds, which rep small % of mutual funds operate like normal corporation bc they sell fixed # of shares and invest proceeds * offer investors easy way to diversify holdings and professional mgmt and liquidity

Role of derivative markets

*More liquid than spot markets -Transaction cost is lower -Less capital is required *More efficient than spot market -Encourage arbitrageurs to participate and drive price to equilibrium -Invoke the law of one price and does not allow arbitrage opportunities to exist for a long time *Can be used to manage risk or to speculate

Mortgage backed bonds and asset backed bonds (taxable)

*Mortgage-backed bonds and the asset-backed bonds, secured by car loans, credit card receivables, and other structured bond issues are usually created by financial institutions that originate the loans that are then pooled and marketed to institutional investors *has grown over last 2 decades *These bonds are sold to investors in the primary market through an investment banking syndicate and are traded in the secondary over-the counter market

Municipal bonds and municipal markets

*Municipal bonds are debt instruments issued by states, cities, municipal authorities and other entities *Municipal bond interest income is exempt from federal and certain state and local income taxation *Investor can compare Municipal Bonds interest income with after-tax income of other fixed-income securities, taking into account the investor's marginal tax bracket *The municipal bond market is a huge, diverse, and extremely complicated marketplace * willing to accept lower yield than on corporate and treasury bonds because of federal income tax exemption *used to fund LT capital expenditures through issuance of LT bonds; fund ST operating expenses through issuance of ST notes. * initially marketed to investors in primary markets by investment bank/underwriting syndicate composed of investment banks, which have either negotiated purchase of bonds from issuer or which have purchased bonds through competitive bidding process. Secondary trading is through a network of financial institutes/dealers in OTC market who specialize in certain sectors of municipal markets. not efficient with large ask spreads.

Yield curve, inflation and deflation

*Nominal interest rate is the actual rate of return or yield associated with an investment (not adjusting for the effect of inflation or deflation) *The real rate of interest is defined as the difference between the nominal rate of interest and the rate of inflation inflation: avg increase in general level of prices (purchasing power of money has decreased) deflation: period of generally falling prices Real rate = nominal rate - inflation rate

Prepayment risk

*Prepayment risk is the risk that a bond will be retired or redeemed at a time earlier than its maturity date *The call options and redemption features in debt instruments introduce uncertainty into the expected cash flows. This uncertainty has a cost, in the way of a higher rate of interest on the bonds *If interest rates in the bond market drop, value of noncallable high coupon bonds can rise substantially. Call option gives issuer ability to call the bonds at a price significantly below value of noncallable bond. * call option cost to issuer is that there is a higher borrowing rate. investors require higher return

Relationship b/w cash and derivative markets

*Prices of assets are related -Costs of storage and delivery are associated with futures and forwards *The concept of arbitrage and the law of one price -Investors constantly check the cash and derivative market to look for arbitrage opportunities (difference exists = put asset where price is low and sell asset where price is high taking difference as arbitrage profit) -The law of one price dictates that the futures price of an asset and the spot price of the asset must be the same on the day future contracts expire

Maturity Intermediation

*Process that an FI performs when it issues ST liabilities and uses proceeds from them to originate LT loans/purchase LT assets *allows FI to create a car loan for borrower for length of time desired by borrower, WHILE depositor owns a checking acct with complete liquidity that satisfies investment desires. * performed regularly by commercial/savings banks, credit unions and other depository institutions when issuing LT loans/mortgages that are financed mostly by ST deposits/savings accounts important roles: * provide investors with additional choices relating to possible investments. *because investors are risk averse, and naturally reluctant to commit funds for LT periods, forces LT borrowers to pay higher interest rate than ST borrowers.

stock valuation approaches: fundamental, technical and MPT

*Professional stock market participants practice a number of investment approaches and techniques which are classified as fitting into one of three camps: Fundamental Analysis, Technical Analysis, and Modern Portfolio Theory (MPT) *The three philosophies have different beliefs about the relationship between the stock prices that we observe in the markets and underlying intrinsic stock values *economic value of an asset: = total cash flow expected discounted to present at a discount rate reflective of time value of money and degree of risk/uncertainty associated with expected CF *DCF applies to all assets

Reinvestment risk

*Reinvestment risk is the risk that arises from reinvesting the periodic interest payments on fixed-rate bonds *An investor receiving payments over the life of a coupon-bearing bond faces the risk of reinvesting coupon payments at uncertain future interest rates than may be lower than the yield on the bond *The yield to maturity on coupon bonds depends significantly on the reinvestment rates *zero coupon bonds have no reinvestment risk. zero coupon yield is yield to maturity/discount rate pn a bond with only one cash flow which occurs at maturity.

management of risk

*Risk is usually measured by the volatility of the rate of return, such as standard deviation *Trade off between risk and return: The higher the return, the higher the risk *Rational Investors are usually risk averse (willing to sacrifice higher returns to reduce risk exposure)

Risk

*Risk-measured by the possible range of returns around an expected return which is measured by standard deviaton of returns. *reflects uncertainty associated w/ expected future returns * part of an assets price movement caused by surprise or unexpected event. Risk has both negative and positive outcomes. Generates returns that are lower than expected or higher than expected.

option contracts

*Strike price -Also known as exercise price, predetermined *Expiration date -After which the option can no longer be exercised, predetermined *Call option - Call option contracts enable the owner to buy an asset at a fixed price on/before certain date - put option contracts enable owner to sell asset at a fixed price on/before certain date * size - amount of asset to be delivered * option contract prior to expiration has + value to owner. The value of the option contract fluctuates minute to minute as a function of change in spot price of an asset, time to delivery and volatility of underlying price movement of asset put and call = most familiar option types w/ individual investors caps and floors = popular with finance institutions many option types trade on stock exchanges

Technical analysis

*Technical analysts believe that stock prices are influenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company. - greed (upside) versus fear (downside) mentality instead of balance sheet and income statement *Technical analysts chart historic stock price movements, volume of trading activity, and the price/volume aspects of related equity and debt markets to predict or anticipate the stock buying behavior of other market participants. *Technical analysts generally have a shorter-term stock holding orientation and more frequent trading activity. * how will participants behave in near term, and how will pessimism/optimism affect their behavior? *use for ST buy sell decisions: if indicators signal stock price will rise, BUY the stock. if they signal SP will FALL, sell the stock.

excess return period and competetive advantage

*The Excess Return Period is the period during which a company is able to earn returns on new investments that are greater than its cost of capital because of a competitive advantage enjoyed by the firm. *Success attracts competitors and over time a company loses its competitive advantage and the return from its new investments just equals its WACC (i.e. investors are just compensated for the risk that they are taking in owning the company's stock and no additional value is created from new business investments). * small cap companies might not get noticed and thus little competition, so ERP is longer * length of ERP depends on products, industry, barriers to to entry (high barrier industry = longer ERP such as 10-15 yr as opposed to avg 5-7 yr) * longer ERP = higher stock value

Spread to treasuries

*The difference between the yield on a non-callable U.S. Treasury bond and the yield on a non-callable corporate bond with an identical maturity is called the spread to Treasuries and is a measure of the default premium associated with the corporate bond *The spread to Treasuries is a function of the type of industry the issuer belongs, the credit rating of the corporate bond and a function of the time to maturity of the bond *depend on default risk and bond rating

Treasury securities and treasury market

*The market for U.S. Treasury securities is the largest and most liquid of any financial markets, many market participants and small bid/ask spreads *Treasury notes have maturities of one-to-seven years, and bonds have maturities of over seven years *These securities pay interest on a semi-annual basis over the life the issue, and then the investor gets the principle back at maturity * inititally offered by Treasury auction, then traded in secondary OTC market. Treasury securities' prices fluctuate daily in response to changes in interest rates and the economy . inverse relationship between interest rate movement and bond prices. * risk free, highly desirable, low rates of return and tax free interest return

Market segmentation hypothesis

*The market segmentation hypothesis or the preferred habitat hypothesis, recognizes that the market is composed of diverse investors who have different preferred habitats i.e. short term and long term investments for the investment requirements *In order to induce investors to move away from their preferred position on the yield curve, an issuer must pay a premium. Thus any maturities that do not have a balance of supply and demand will sell at a premium or discount to their expected yields and the shape of the yield curve is dependent upon demand and supply * therefore, there's no formal relationships between expected future/ST spot rates and implied forward rates

Duration

*The price volatility of a debt issue is measured using duration *The duration of a bond is measured in units of time (for example, 7.3 years). *In the simplest case, the duration of a zero coupon bond is equal to its current time to maturity *The higher the current coupon payments, the lower the price volatility and the shorter the duration * measures weighted average maturity of bond's cash flows. * percentage change in price of asset divided by change in interest rates: D = (-∆P / P)/ ∆Y D = duration, P = dollar price of a bond, ∆P = change in dollar price of bond, y = market yield, ∆ y = change in market yield *reduce volatility and duration with hedging and derivative securities * inverse relationship between interest rate movements and bond prices * if interest rate increases price falls and resulting yield will decrease to be in line with other interest rates

Valuation of derivative securities

*The value depends upon the value of the underlying simple securities or building blocks * based on underlying components, depends on structure of cash flows *The value is usually based on following inputs: -The spot price and movement of the underlying assets -The amount of time to the expiration or delivery date -The exercise price -The risk free rate of interest corresponding to amount of time to delivery date -For option, the volatility associated with return/price of the underlying assets * can be + or - depending on if security is long or short the component

Yield curve

*The yield curve is the relationship between the yields and the maturities on Treasury securities. *The yield curve usually is positively sloped which means that investors require higher returns for longer maturity Treasury securities. - This is because the prices of longer maturity bonds are more volatile and therefore are viewed as being riskier than shorter maturity securities

Call features and other factors

*The yield level on a bond is influenced by its liquidity, call features and other factors *With greater liquidity (like US Treasury) the bonds are more marketable and there is less of a liquidity yield premium associated with the bond *Investors analyzing a corporate, municipal, or asset-backed bond assign a premium in the way of a higher interest rate to reflect any optional and extraordinary call provisions in the issue

Capital Asset Pricing Model (CAPM)

*Theory about pricing of risky asset and tradeoff between risk of asset and associated expected return *From the Risk-Return Line, we can estimate the expected return on a stock, E(Ri); expected rate of return on risky asset i * Expected return on stock (i), E(Ri) equals the Risk-Free Rate (Rf) + the stock's Beta (ßi) times the Market Risk Premium—the return on the market (Rm) minus (Rf). E(Ri) = Rf + ßi * (Rm - Rf) * E(Rm) = rate of return investor expects by placing money in well diversified portfolio of stocks. *FSR = extra return (- or +) received by firm due to some event affecting only that firm. base rate of return: expected return on every risky asset should be at least that of risk free rate of return.

bond rating

*Three rating agencies - Moody's Investors Services, Standard & Poor's Corporation, and Fitch Ratings Ltd. specialize in rating the default risk and credit worthiness of a bond issue and of corporate, municipal, and even sovereign government issuers *The agencies then assign the issue with a bond rating that ranges from the equivalent of AAA, the highest grade with a very remote chance of default, down to CCC, the lowest grade and currently in default *The ratings have significant bearing on the required yield on a bond in the marketplace * many financial institutions (ie mutual funds anf certain depository institutions are restricted from investing in bonds that are rated at a level lower than an investment grade which the mkt generally defines at a level of BBB- or higher. - once lower than this, fewer investors buy the bond and yield increases significantly

Valuing a bond

*Two important facts associated with valuation and bond prices in the marketplace are: *Bond prices and changes in interest rates move in opposite directions *Investors and traders value and bonds based on a price to worst call feature scenario; i.e. issuer of the bond will act in its own best interest in calling or managing the bond's call features and will exercise the call at the first available opportunity that is economically advantageous to the issuer

pure expectations hypothesis

*Under Pure expectations hypothesis the yield curve can be analyzed as a series of expected future short-term interest rates that will adjust in a way such that investors will receive equivalent holding period returns *Thus the expected average annual return on a long-term bond is the compound average of the expected short-term interest rates *Thus an upward-sloping yield curve means that investors expect higher future short-term interest rates and a downward-sloping yield curve implies expectations of lower future short-term rates - indifferent about whether they hold a 20 yr investment, 20 consecutive 1 yr investments, or 2 10 yr investments

Investment valuation

*Value = sum of expected cash flows discounted for time and risk. *2 basic uncertainties: amount of expected Cash flow and the discounting rate that we use in calculating present value * most cash flow expected to receive are promised interest payments and repayment of principal at maturity or payment of a redemption price (might include call premium). * discounting rate to use is bond yield

CAPM and well diversified portfolios

*WDPs are not risk free. *reduces unsystematic risk to close to zero, but still have mkt or systematic risk! *only uncertainty is that of performance of mkt in general * portfolios with high risk stock have high beta, and those with low risk stock have low beta * well diversified portfolios are identical except for their betas. no fsr. simply follow the market, magnifying it if beta is greater than one and dampening swings with beta of less than one

Incremental cash flow

*can be hard to estimate * changes in company's future cash flows that result directly from company undertaking the investment *concerned about financing costs associated with project and any increase in net working capital, that will require firm to finance inventories and accounts receivable associated with project

valuation categories

*cash flow from operations: operating inflows - outflows. this is discounted at WACC/timing of ECFs *corporate residual value: NOPAT at end of ERP, divided by company WACC and discount at WACC to today's value. at the end of ERP, corporation is receiving ROI = WACC, so NPV of additional investment is 0 and no additional value is created *ST assets: include real current assets that could be sold/liquidated close to face value ie securities, inventories, acct receivable, etc. don't include intangibles like goodwill or LT assets like property/plant/equipment corporate value = cash flow from operations + RV + ST assets use to find intrinsic stock value: IS = CV - debt - preferred - ST liabilities)/shares outstanding

Savings and loan associations

*early 1800s: commercial banks principal assets were ST loans to businesses. nothing existed for individual needs. *1816, congress passes regulations allowing mutual savings banks and savings/loan associations that were created to make home mortgage loans to families. * take deposits and make loans, but they focus on home mortgage/personal loans * accept savings accts from small depositors and use this money to fund LT mortgage loans. * thrived until early 1900s during great depression; struggled in late 70s/early 80s * 1200 in US, currently shrinking in # *more highly levered than commercial banks, dominant assets = local single family home mortgages

financial intermediation

*financial institutions = middlemen in capital mkts *FIs borrow funds from savers/investors by issuing a claim - secondary security (deposit ie savings or checkings or contract ie insurance policy or pension obligation) and uses these funds to make loans at higher interest rates - primary security * secondary securities include: savings, checkings accts; annuities, insurance policies, pension plans, mutual funds. fulfill 1+ need of clients depositing and borrowing with institution. cost/yield associated *primary securities = loans, mortgages, stocks, bonds and other assets w/ higher yields. interest, dividends, principal and gains from PS + other assets of FI pay cash flows associated w/ lower yield 2nd securities *activities underlying most FIs are based on buying + selling claims to diff streams of money

Insurance

*pay a premium to protect against specific loss but you don't surrender possibility of a gain *Insurance contracts - Cap-Limitation of the amount of money paid under a claim - Deductibles - owner pays for a specified portion and insurance covers the rest - exclusions - events specifically excluded from triggering a payment under a policy *Option -Financial assets that have characteristics similar to insurance contracts -Represents the right - not obligation - to sell or purchase an asset at a fixed price at a fixed time in the future * European option: if it can only be exercised at a certain date/time period in the future * American option: may be exercised at any time up to and including exercise date

Sinking fund redemption

*pre-specified most corporate and municipal bonds have maturity date are subject to annual call in accordance with prespecified redemption schedule * many otherwise noncallable bonds can be subject to this schedule *increases uncertainty of cash flows and retards upwards price movements of a bond in event that interest rates drop *extraordinary redemptions in municipal and asset backed bond markets make expected life of bond cash flows a source of confusion. *different types of bonds have extraordinary redemption provisions that, in event of certain occurrences, present possibility of unexpected mandatory redemption and a truanction of cash flows.

Securities and Exchange commision

*principal regulator to all primary/secondary financial mkt activity in US is SEC * created by Securities exchange act in 1934 * responsible to - license professionals - collect public disclosure info - enforce securities laws in US - primary objective!!*: provide investors w/complete disclosure of material info concerning publicly traded securities - create level playing field/minimize assymetries - regulates secondary securitites mkt prior to SEC, securities act of 1933 regulated primary securities by providing investors with necessary info to make informed choices

Investment Return definitions

*return = (change in price + cash payment)/purchase price *return on a stock: dividends plus appreciation (capital gain) or minus depreciation (capital losses) *return on a bond: periodic interest payments (usually every 6 months) and repayment of principal. may also have capital gains/losses with bond if sold prior to maturity. *dividends/interest paid = ordinary income, added to taxpayer salary to get total OI for the year *capital gain is a positive change in price of stock, bond or other asset. only realized gains are taxed (if you sell the stock at higher than what it was bought for). if the stock price goes up and you don't sell it, it's unrealized (continue to own it) * long term capital gain: if asset is held for a year or longer - taxed at lower rate usually * short term capital gain: asset held for less than a year *capital loss: negative change in price of stock, bond or other asset. - may reduce federal/state income taxes

Hedging

*sacrifice gain to protect against loss * reduce your exposure to a decrease/increase in asset price or return associated with investment *There are three types of hedging instruments - Future contracts ~ A forward contract with standardized terms that trades on an organized exchange - Forward contracts ~ A written agreement between two parties that is not traded on an organized exchange - Swaps ~ An agreement between two or more parties to exchange sets of cash flows over a period of time ~ Interest swap and currency swap ~ multiple #s of forward contracts and payments made are called notional amount: agreed upon principal, similar to size of forward contract on which financial contracts/swap payments are based

annuity

*savings *lower interest rate than mortgage or loans (borrowings) *more complex amortization schedule financial contract sold by pension funds and life insurance companies that pays a specified amount of money per month or year to purchaser, his benificiary or the owner of the contract. either lump some or series of periodic payments which is invested in contract with institution. principal compounds over time at pre determined interest rate/yield and at some point, usually after retirement, annuity generates periodic payments.

Investment banks

*set of activities that financial institutions - usually stock brokerage firms, commercial banks - conduct in capital mkts to help origination/sale of securities to investors * transactional intermediaries - link investors and borrowers *involves very ST holding of assets issued by clients prior to sale of those assets to ultimate investors * make money through underwriting fees charged to issuers of securities *lend their own funds to clients and make asset/liability and risk mismatches to earn profit based upon cost of funds and yield on assets/investments * instead of accepting/loaning deposits directly, they link investors to issuers through sale of primary securities * provide strategic/financial advice, lend/invest firm's own capital, provide research for securities/mkts and trade securities for clients/their own acct and manage investment portfolios. * 3 divisions: -corporate finance/investment banking: handles underwriting, mergers/acquisitions, restructuring -sales and trading: interact with clients and financial markets to mkt and trade securities. assigned clients/cover clients/contract traders to execute transactions * when an agent, just a middle man b/w buyer/seller but when principal it buys/sells for benefit of the firm -research dept

Investment intermediaries

*such as mutual funds, investment and finance companies. common element is that investment intermediary pools resources of many small investors by selling them shares and then uses proceeds to buy securities. clients get benefit of lower cost and diversified portfolios and pay a mgmt fee and for services performed

Interest rate risk

*the most difficult risk to assess *The price volatility of a bond is the extent to which its price changes with fluctuations in market levels of interest rates *Bond prices and yields move in opposite directions, other things being equal. The magnitude of price movements will differ based on specific bond characteristics * price volatility of a bond is directly related to its maturity - longer maturity = sharper price adjustment for given change in interest rates than otherwise identical shorter maturity bond and greater risk *The lower the coupon on a bond, the higher the price volatility, the greater the risk

Bond

- A bond is a debt financial contract under which the issuer is obligated to make periodic interest payments and repay the principal at some pre-determined time - The legal agreement between the issuer of the bonds and the investors is the indenture - The amount that is originally borrowed and the amount that is repaid when the bonds mature and the principal payment is due is known as principal value, or par amount or a maturity value - most common has fixed rate and known maturity

Tests of market effiency

- Goal of many of the studies is to find investment strategy that produces investment returns greater than a long-term buy-and-hold strategy for a diversified portfolio of stocks. - The majority of studies have shown that new information is quickly incorporated into stock prices. The excess returns arbitraged away and that stock market is relatively efficient, or at least semi-efficient. event study: examines movement of stock prices for a certain number of days prior to an event (ie earnings announcements) until a certain number of days after event. *goal; understand/capture unusual stock price reaction to the event and determine how quickly/completely price of stock reacts to the event. stock returns typically are adjusted for general movement of prices in stock market.

Structure of Interest Payments on a Bond

- The coupon rate or interest rate on a bond is the rate, expressed on a percentage basis, at which interest accrues or is paid by the issuer to the owner of the bond - Interest rate setting structures vary and can be broadly classified into two categories - Fixed Rate Structures (fixed coupon bond) - Floating Rate Structures - Interest rate setting structures affect the value of a bond

investment bank services

- advise issuer of securities and originate financing - can give issuer insights on state of capital markets and features that investors prefer - underwriting the financing: guarantee price/yield on security to issuer. underwriting syndicate = group of investment banks that share profits/risk in transaction - distributing financing to ultimate investor: find potential investors, offer to general mkt

Dodd Frank Wall Street Reform

- increased government oversight of certain trading like derivatives. Regulate important financial institutions. This was done to prevent the collapse of something like Lehman Brothers again. Regulate mortgages and other financial products. - signed by Obama in July 2010 - subject to much debate, took over a year - council of regulators led by Treasury Secretary to oversee industry and ID threats to system * review bank and non bank companies to determine stability and if collapse will threaten system * if a threat, it will be dismantled and Treasury will pay obligations to prevent taxpayers from having to pay for failed company - majority of derivatives must now be traded on exchanges/through clearinghouses in attempt to regulate derivative mkt - banks can't trade most complex/risky derivatives anymore but can trade those that are not that risky. if a company creates derivatives, must set aside money to cover losses * exceptions: companies that trade derivatives strictly to offset business risk, but must report these trades; custom derivatives - increased regulation over credit rating companies, holding them more accountable - overhaul of lending practices. lenders must verify borrowers have income/financial history to support mortgages, and also must keep 5% of mortgage on the books - must take losses on defaults

floating rate structures

- initially interest rate setting mechanisms were based upon some interest rate index or level of a risk free security - Over the years, rate setting mechanisms have been developed that are designed to create a bond that always trades at or near par value - Historically, the floating interest rates have been significantly lower than the rates on fixed-coupon bonds. However, the issuer retains the interest rate risk inherent in a bond issue - take advantage of upward sloping nature of yield curve - problem: failed auction, not enough bidders tp purchase auction rate bonds from sellers. max interest rate is determined and bond owners wanting to sell bonds at par value couldn't - interest rate on bond increases as interest rates in bond market increases so issuer of floating rate bond retains interest rate risk associated with bond issue.

Financial policy of the fed

- last 15 yrs: focused on low inflation, unemployment and stable economic growth (under Ben Bernacke) - 70s and 80s: focused on fighting double digit inflation by having a goal of steady money supply, allowing interest rates to fluctuate based on fixed $ supply (under Paul Voelcker) -today, monitors money supply and interest rates in attempt to keep economy out of a recession and minimize inflation/interest rate volatility

Behavioral finance

-Academicians who specialize in the field of behavioral finance, have challenged Modern Portfolio Theory's assumption that investors are rational and markets behave rationally. -Behavioral theorists have conducted studies that show that stock markets were not efficient and people and markets, at times, behave irrationally. *investors hate losing, causing them to hold onto losing stocks longer than they should; * investors are often ill informed and tend to overreact or underreact to new information. * investors love patterns (tech. analysis based on observing patterns in price/trading volume) and tend to find them where they don't exist. * investors are overconfident in stock-piling abilities and tend to be overoptimistic. causes investors to think they're smarter than they are and underestimate risk.

Ways to reduce risk associated with financial assets

-Diversification *Spread the risk by investing in a number of risky assets -Hedging *By using techniques to lock-in a price or return -Insurance *Pay a premium to purchase a contract to protect -Sell the assets

fama and French study

-Fama and French study compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics -The study showed, among other things, portfolios of stock with a high book value (BE) to market value (ME) ratio consistently outperformed portfolios with low (BE/ME) ratios and called to question the validity of efficient capital markets -Finds that stocks with low p/e ratios outperform stocks with high p/e ratios; -Stocks with small market caps outperform stocks with large market caps. Other researchers find roughly the same results. looks from july '63 to december '90

Solving for IRR

1. Estimate NPV from the machine based on a discount rate. 2. Since the NPV calculated at step 1 is positive we increase the discount rate because IRR is the rate at which NPV of the project is 0. 3. We continue the process till we find the rate at which NPV is 0 4. We now compare the IRR calculated with a pre-determined required rate of return and apply the IRR rule to make the decision.

Calculate NPV

1. Estimate cash flows 2. calculate discounted cash flows 3. calculate NPV and make decision based on NPV rule

uneven cash flows of stocks and bonds

A bond is a debt instrument. Corporations, the US Government, and municipalities issue bonds. Bonds are payable from taxes from US government or the general revenues of a corporation. Cash inflows to an investor are bond interest payments, usually every 6 months, and repayment of principal. A stock represents ownership interest in a corporation. The cash inflows consist of dividends and increase (or decrease) in stock price. There is no maturity associated with a stock—the life of a stock is infinite. The risk of a stock is hard to quantify, making it difficult to determine the proper discounting rate.

Consumer Financial Protection Bureau

A federal statute that requires increased disclosure of credit information and terms to consumers and regulates consumer credit providers and others. Created by Dodd Frank Bill *housed by Fed *eliminate deception *can write rules, ban unsafe product

Hedge funds

A hedge fund is a private partnership that uses advanced investment strategies to generate high returns for wealthy investors and institutions There are an Estimated 6,000 HFs They Follow Different Investment Strategies Strategy is critical, but very few actually hedge There have been Great Successes (Soros, Icahn) but also Many Catastrophes - LTCM and Ponzie Schemesr Lax Regulation Hedge funds are largely unregulated because they cater only to large, sophisticated investors Exclusivity The minimum investment in a hedge fund is usually in the millions of dollars Illiquidity Investors must commit money for at least one year 2-20 Fee Structure

Evidence on Individual Investors

A study of 60,000 individual accounts at a discount brokerage firm showed that trading costs negatively and significantly affect the returns of market participants. Investors can improve returns by reducing transactions costs to the lowest level possible.

asset backed debt

Asset-backed securities are secured by the sponsor (usually large financial institution) that has originated the loans and who structures the financing and usually purchases credit enhancement/letter of credit for insurance, and markets asset backed debt to sophisticated investors responsible to monitor/service the loans can be portfolio of mortgages or car loans or credit card loans, etc. very strong security features, some are in highest rating categories

Book Rate of return

Book Rate of Return-an accounting ratio calculated by dividing the company's accounting profits by the book value of the company's assets. Book rate of return rule as an investment criterion: accept the investment if its book rate of return exceeds a predetermined target book return; reject the investment if its book rate of return is less than a target book return.

Bank assets, liabilities and income

CBs = highly levered companies * banks sell liabilities, time deposits/savings accts, borrowings and bank capital for assets, bank prefer ST business related loans w/ variable rates of interest. balance sheet for bank: total assets = total liabilities + capital * make money borrowing at a low rate (interests paid on deposit) and lending at a high rate (interest rate earned on loans). *principal revenue source * in addition to spread b/w borrowing/lending rates, banks generate revenues from fees charged on transaction processing, credit apps and business lending services - provide numerous product/service to link lenders/borrowers

optimal redemption

Call Option: Issuer's option to redeem bonds prior to their stated maturity, at a pre-determined price above par value Call Premium: The excess amount of the call price above the par value. Call option can be exercised on or after predetermined date - usually 5-10 yrs from date of issuance An investor that owns a callable bond is subject to considerable uncertainty about cash flows on its callable bonds and hence will require a higher yield on callable bonds than on comparable non-callable bonds Optimal time for issuer to exercise call option is when it is financially desirable: interest rates drop, and issuer can refinance at a lower rate. many asset backed securities and municipal bond issues have unusual mandatory/extraordinary call features makes valuation tough bc of uncertainty of cash flows

Capital Budgeting

Capital budgeting-process of planning and managing a firm's long-term investment in projects and ventures Capital Budgeting involves estimating the amount, timing, and risk (how likely is receipt?) of future cash flows Capital budgeting: starts with estimation of incremental cash flows from a project; create a time line of expected cash flows; and compare the present value of the cash flows with cost of project *most critical decisions that mgmt team must make *relate to fixed assets of firm - what it does, makes and industries in which it's involved. *very complex. might have lots of opportunities (mutually exclusive - if one is chosen, alternative must be excluded)

DCF Valuation

DCF determines the value of an investment. The markets determine the price of an investment. You decide, based on price or cost, if the investment is undervalued (buy it!), overvalued (sell it! or wait for price to drop if you want to buy it), or fairly-valued. Your buy/sell decision should be based solely on price versus value. *favored approach to analyze budgeting and investment decisions

ERP categories, 1-5-7-10 rule

Depending upon the excess return period companies can be grouped into 4 categories: *Boring companies - operate in a highly competitive, low-margin industry - a 1 year excess return period *Decent companies - decent reputation, don't control pricing or growth in their industry - a 5 year excess return period *Good companies - good brand names, large economies of scale - a 7 year excess return period *Great companies - great growth potential, tremendous marketing power, brand names - a 10 year excess return period

Evidence From Mutual Funds

Evidence From Mutual Funds: Studies of Mutual Funds using gross returns have shown that mutual funds do no better than to lie on the risk-return line (alpha of zero). Net returns (gross returns less fees) give a negative alpha. In an efficient market, funds with the lowest fees have the greatest alpha. some fund managers are lucky and some unlucky no group of managers shows abnormally good investment returns

Unsystematic Risk

Firm specific risk (FSR)= risk caused by surprise event that effects one company, like accounting irregularity, new drug discovery, etc. Unique to a stock on an industry sector. Effects greatly reduced by proper diversification of assets in a portfolio. Stock market doesn't reward investors for unsystematic risk bc it can be minimized or eliminated through proper diversification

bonds and risk

Four types of risk involved while investing in fixed-rate or fixed-coupon debt obligations are: *Default risk - the risk that the bond will not pay interest or principal when due *Reinvestment risk - the unknown rate at which cash inflows may be reinvested *Prepayment risk - when an issuer calls a bond prior to its maturity *Interest rate risk - the risk that a change in market interest rates will affect the value of the bond

Historic risk and return by asset class

Historic rate of returns, Ibbotson and Sinquefield: Treasury bill: return = 3.8%, standard dev = 3.2% gov bonds: return = 5.3% SD =9.4% Corp bonds: return = 5.8%, SD = 8.6% large co stock: return = 10.7%, SD = 20.2% small co stock: return = 12.5%, SD = 33.2%

mortgage

Home mortgage: an obligation under which a person borrows money from a bank and uses the proceeds to purchase a house or condominium. Amortization schedule: Level payments over a long time period, usually 20 to 30 years. *if mortgage interest rates rise, bank increases lending rates on new loans to cover higher mkt interest rates bank offers to attract deposits * if they fall, bank must decrease lending rates to compete for new loans, and due to this, cost of deposits will drop

Beta

How do we measure risk of an asset? Beta Relation between beta and return: positive magnifies market return *appropriate measure of risk for any investment A stock with a beta of 2 will tend to double market movements (up or down) A stock with a beta of 0.50 will tend to have movements (up or down) equal to ½ the market Measured by 60+ pairs of monthly or weekly returns for performance of a stock vs performance of a stock mkt index. They will have stock mkt index return on horizontal axis and firm return on vertical axis. Plot them and use regression analysis to fit line through. Slope of line is estimate of beta * if theres no FSR, each point is on the regression line. for each point, the vertical distance from the point to the line measures firm specific return for that time period. *if the point is above the line, company experienced good firm specific return * if point is below the line, company experienced bad firm specific return *steeper line means firm's return is more sensitive to return of overall market. greater beta = higher market risk

Internal Rate of Return

IRR-rate of return expected to be earned on a project. IRR-discounting rate that makes the net present value of an investment equal to zero IRR Rule as an investment criterion: if the investment has IRR that is higher than some pre- determined required rate of return, accept investment.

Terms of Bond Issue

Indenture: legal agreement between issuer of bond and entity/trustee that represents investors that own the bonds. usually major commercial bank *monitors terms, determines if issuer is in violation of legal agreements, collects interest and principal/distributes them to investors *specify security associated with bond issue: money issuer pledges to pay, how investors are protected, what rights investors will have if issuer fails to make scheduled payments, does issuer have right to repay principal prior to specified maturity date. has a principal value, par amount or maturity value * amount repaid when bond matures and principal payment is due has periodic interest payment

Intrinsic and time value

Intrinsic value = S - Xc The amount the option is in the money and is the difference between the current price and the strike price of the option. Time value = mkt price of option - intrinsic value Reflects expectations of an option's profitability associated with exercising it at some future point in time

Evidence from real world

Less Technical Evidence from the Real World: Evidence indicates stock price changes are independent. Evidence indicates stock prices react quickly to news and excess returns are arbitraged away.

Loans

Level cash flows: the interest rate and cash flows associated with the loans, mortgages, and annuities are fixed and do not change; A loan is an obligation under which a person borrows money from a lender; *lender requires security (lien) which is released once loan is fully paid off. you then own it free and clear Terms of the loan state an interest rate and a repayment or amortization schedule

Expected return on risky asset E(Ri)

Measured by a statistic called the standard deviation of returns. ROR investor expects to receive on risky asset over time. interim cash flow payments (ie dividends) plus/minus any changes in price of asset over time.

Alpha

Measures performance. Positive alpha (vertical distance above risk-return line) is good, negative is bad risk return line = zero talent line, performance below it is POOR = observed return - expected return applied to mutual funds: Gross Return means "before expenses" Net Return = Gross Return - Expenses

Valuing uneven cash flows of projects

Most real world investments such as projects, stocks and bonds do not have a single cash flow or level expected cash flows. A project or venture is an investment to produce a product or provide a service that will generate money in the future. *usually increased cash flows over time as marketing increases or inflation increases prices. *or revenues decrease bc of competition Cash Inflows- additional revenues coming into the company as a result of the project. Cash Outflows- additional expenses being spent by the company as a result of the project. Accept if the present value of the cost associated with project is less than value of projected DCF and reject if costs are higher

net present value

NPV of an investment-difference between the value and cost of investment. The value of any project is equal to the present value of its expected cash flows, discounted for risk and timing. Goal of financial mgmt investors is to create additional value for stockholders by investing in projects or ventures worth more than they cost NPV Rule-invest in projects if NPV is positive. Reject if NPV is negative value of company stock SHOULD increase by NPV associated with investment. goal is to fund only investments with + NPV

valuing an option

Option S = current market price of security underlying the option Xc = exercise price or strike price on the call option Xp = exercise price or strike price on the put option *The call option is in the money if S >Xc *The put option is in the money if S < Xp *An option has positive value to its owner before expiration *The price or value of a call or put option has two components: Intrinsic value and Time value

Payback Period

Payback period-length of time for the return on an investment takes to cover the cost of the investment. Payback period-involves only gross cash flows and not discounted cash flows. Payback rule as an investment criterion: accept the investment if its payback period is less than a predetermined number of years; reject the investment if its payback period is greater than the predetermined number of years.

relative valuation analysis

Relative value analysis employ measures of value such as P/E ratios, price/book values (P/BV), price/sales (P/S), or the price/earnings/growth (PEG) ratios for a company and compares them with those of similar stocks and industry peers *P/E quoted most frequently by media (simple to compute/understand)

Return to stockholders

Return to stockholders includes any dividend payments plus the increase (or minus the decrease) in stock price that investors experience during an investment holding period % Return = (Dividends + Change in Stock Price)/Beginning Stock Price *return can be negative even if company had a successful year from operations/earnings due to systematic risk, corporate governance or acctg scandals * can very positive even if the company had mediocre/poor performance, or a takeover/tender offer

standard deviation of return σ

Risk on an asset is measured by the variability of returns Standard deviation is the statistic that is that measures how wildly or tightly observed stock returns cluster around the average stock return Greater standard deviation means more fluctuations and greater risk that expected return will not equal actual return Measures expected spread of observations around average of returns risk has positive and negative implications

Simple average returns versus compound average returns

SIMPLE AVGs ARE NEVER SIMPLE Many investment managers and advisors use simple averages to portray their historic performance However, simple averages are a misleading way to assess investment returns—compound or geometric averages are far more representative of actual investment performance Geometric average is calculated as below: [( Value at the end of the period / Value at the beginning of the period) ^ 1/T ] - 1 Where T is the number of years in the compounding period The math underlying investment returns and percentages computes investment gains more favorably than comparable losses. Problem is embedded in calculation of simple averages. If there is a negative percentage return the calculation of a simple average is biased upwards. Simple average returns can hide very poor performance.

Treasury Bond security

Securities that are issued by the U.S. Government are usually assumed to be risk-free. Assumed to have no credit risk. Security underlying is the power to levy taxes. borrow money, and print money to pay obligations. *financial mkts use interest rate/yield curve of US treasury bonds as the measure of the time value of money. Treasury yield curve is the set of base yields/interest rates from which all other debt securities are priced.

Fixed rate structures

The coupon rate and payments are fixed over the life of the bond, and the investors and the issuer are certain of the payments

contract aspects

Some terms relating to hedging: -Hedgers (investors that use instruments to reduce risk) and speculators (investors that use instruments to increase risk) - delivery date of commodity determine when contract is entered into -Long position (party agreeing to buy commodity) and short position (party agreeing to sell commodity) -Value (size times forward price) and size (amount of commodity to be delivered) of a contract -Spot price (current market price of commodity for immediate delivery, changes every minute) = futures price on day of delivery - forward price (purchase price) determined when contract is entered into, usually structured on forward contract so value of contract is initially 0. - cost of carry: costs (storage, transportation, etc) are embedded in futures price and effectively make hedger receive lower price for the commodity to pay for shifting the risk for another entity *****When an investor hedges, he fixes the sales price for the asset and gives up any upside gain for offloading the risk of loss.

calculate SD

Step 1 - Take the simple average return of the distribution of returns Step 2 - Take each individual observed return and subtract the average of the returns Step 3 - Square the resulting difference, and add the squares to get the sum of the squares Step 4 - Divide the sum of the squares by (the total number of observations minus 1)—the result is the variance of the distribution. Step 5 - The square root of the variance is the standard deviation of the returns

total risk

Stockholders face two types of risk: systematic risk and unsystematic risk Total Risk = Systematic Risk + Unsystematic Risk *Systematic risk -Represents the risk of the stock market -It is caused by economy, taxes, and other market factors -It can not be diversified away *Unsystematic risk -Is specific to a company

Exceptions to estimating future cash flows

The Bond and the mortgage have cash flows that are known with certainty, while the range of future cash flows for a stock can be enormous. Actual cash flows can be lower for a mortgage in event of default, but not higher. Common stock represents ownership in a corporation, which has an infinite life unlike bonds and mortgages. must value to infinity

Security for Bond Issues

The sources of security on a bond issue can vary a great deal, and will affect the credit rating and creditworthiness of the issuer

Term structure of interest rates, default risk , other factors and bond yields

The yield or return that an investor should expect to receive on a financial asset such as a bond is a function of a number of factors, the most important of which are: - The time value of money (repped by yield on risk free Treasury securities known as term structure of interest rates) - The default risk associated with a particular security, measured by rating category for security and measure of spread to treasur - The liquidity premium and other bond specific factors specific to the financial asset, such as call provisions

Tradeoff between return and risk: CAPM

Trade-off between the expected return on an investment and its risk. Low risk Treasury Bills have lower expected returns (2-4%). Stocks (large price volatility) have higher expected returns (e.g. 6-10%). Risk measured by price or return volatility. More price/return movement—greater risk. A rational investor requires a higher expected return to accept additional risk. Model that describes this trade-off is the CAPM. Direct tradeoff between the expected rate of return and risk. Tradeoff represented by the diagonal line (positive, direct relationship) * As the inherent risk increases in an investment so does the expected return!!!

Mutual fund performance

Using gross returns, the average fund has an alpha of 0% What is the average alpha using net returns? -1.2% Is good performance in the past (using gross returns) an indicator of good future performance? NO!! 89% of funds failed to match the S&P500 over the past 5 years Index Funds are hard to beat

Perpetuity, Capitalization, Enterprise value, market equity

asset with stream of even cash flows that continues to infinity. *calculated by dividing level annual cash flow associated with perpetuity by discounting rate. *calculate level cash flows by capitalizing expected annual cash flows at yield required by market. capitalizing means to divide amount by number between zero and one * enterprise value/market cap: total value (debt plus stock) of a company. * market equity: total common stock value of company AS INTEREST RATES GO UP, VALUE OF FINANCIAL ASSETS GO DOWN AND VICE VERSA GREATER PROFITS INCREASE STOCK MARKET VALUE AND LOWER PROFITS DECREASE STOCK MARKET VALUE

Volcker Rule

ban of "proprietary trading" (when banks invest with their own capital to make profit for themselves instead of clients. also limits bank investment in hedge funds and private equity funds. attempts to minimize effect that stock market pull back would have on financial stability of these banks

normal distribution

bell curve (symmetrical). most theories regarding pricing of financial assets assume distribution of returns for assets follow normal distribution. shape determined by mean of observations and SD of observations 2/3 will be in a range of + or - one standard deviation around the average 95% will range between plus or minus 2 SDs

Market risk premium [E(Rm) - Rf]

equal to expected return on stock market minus the rate of return on risk free asset. Additional return investors expect to receive if they buy a stock of average risk (beta = 1.0) as opposed to a treasury bond. INCREASE when investors are more risk averse, DECREASE when less risk averse

Target stock price analysis

forecasts earnings per share (EPS) of a firm and multiplies EPS by the projected P/E ratio to arrive at a target stock price.

Expected return on portfolio of risky assets

expected rate of return on each risky asset in a portfolio multiplied by portfolio weight. portfolio weight is percentage of total portfolio value invested in each risky asset

Beta (Bi)

measure of systematic risk of an asset. market has a beta of 1.0. Beta of a stock with price movement similar to market also has beta of 1.0. Stock with a price movement greater than that of S&P 500 has beta greater than 1.0. Stock with avg price movement less volatile than market has beta less than 1.0

capital budgeting procedures

once an asset, project or venture has been identified as possible investment candidate, first step is to estimate incremental cash flows - costs and benefits of accepting/rejecting project.. basic unit of time segmented into/analyzed by month or year typically but can be different create timeline of future cash flows. ID incremental cash flows associated with project and then compare present value of cash flows to costs of purchasing asset or acquiring/building the project. use diff investment techniques to compare benefits - uncertain, spread over several future periods - associated with accepting project, and costs associated which usually are incurred before benefits are received

Beta, firm specific return and diversification

portfolio's FSR can be made small by investing in large # of companies bc one can be negative, the next can be positive, thus canceling each other out. INVESTORS WITH LARGE PORTFOLIOS ARE UNCONCERNED ABOUT FIRM SPECIFIC RETURN OR RISK. PROCESS OF DIVERSIFICATION INVOLVES INVESTING IN ENOUGH FIRMS THAT FSRs OF INDIVIDUAL COMPANIES TEND TO CANCEL EACH OTHER OUT. portfolio is well diversified if FSR is so small that it is insignificant 20 unrelated stocks seem to be sufficient for a fairly well diversified portfolio.

expected return on market E(Rm)

rate of return investor expects to receive on diversified portfolio of common stock. Expected return on market is usually measured by recent average return on stock market

expected return on risk free asset Rf

rate of return investor receives on safe asset - free from credit risk. obligations of US treasury = risk free (assumed) bc US gov will always meet financial obligations.

What causes share prices to change?

receipt of new information. *immediate adjustment: what happens if share price reacts immediately to new info. THIS HAPPENS IN AN EFFICIENT MARKET * gradual adjustment: what happens if share price reacts slowly, which will often result in abnormally high or low returns. EFFICIENT MARKETS DO NOT ALLOW THIS we cannot predict the next bit of news. it's not news if it's anticipated and then actually happens but it is news if what happens is different from what was anticipated

Systematic risk

risk caused by surprise event that effects entire economy and all assets to some degree, like increase in interest rates, terrorist attack, or declaration of war. level of systematic risk can't be reduced by diversification. expected return depends only on systematic risk.

Default risk

risk that issuer of bonds will not pay interest or principal on bonds only US treasury bonds have no default risk other bonds must offer greater return as compensation for added risk *spread to treasuries = yield on non callable bond - yield on non callable bond w/ identical maturity - measure of default premium - function of type of industry, credit rating (lower CR = greater S2T) and time to maturity (longer term = higher S2T)

Municipal Bonds

second most secure class of bonds. *Municipal bonds may be secured in a variety of ways such as by the issuer's taxing power, revenues and credit enhancement devices * issued by cities, states, municipalities and their agencies. *secured in variety of ways: - general obligation bonds: secured by issuer's taxing power, which might be limited or unlimited and other revenues of the issuer. - revenue bonds: payable principally from revenues generated by the facility or system constructed with proceeds of bonds -secured by credit enhancement devices like MB insurance and commercial bank letters of credit

corporate bonds

security is most often an unsecured promise by the corporation to pay its debts. Sometimes the bonds will be secured by collateral or a mortgage on a particular property or piece of equipment restrictive covenant: specified in the indenture for it to perform certain actions or prohibit certain activities may be secured through collateral or additional mortgage more likely to default than treasury/municipal bonds. no taxing power or ability to control delivery and pricing of essential services, such as water and sewer, trash collection and electric power; at the mercy of marketplace and the corporation's level of profit/loss

Portfolios

specific securities owned by investor. each has a beta and portfolio specific return component portfolio return is a weighted average of returns. weights are fractions invested in each security. portfolio's beta and FSR's are weighted based on this fraction. FSRs are not connected/don't effect each other bc they are connected to diff firms, but the market return affects return of every security invested in the portfolio.

Risk Premium + risk/return tradeoff

standard example of risk free asset is ST T-Bill if you expect to own Tbill to maturity its beta is 0. return doesn't depend on market return You can have a portfolio with beta equal to any number preferred by allocating money b/w T-Bills and overall mkt in proper proportions. What is a risk premium? The amount by which an investment is expected to outperform T-Bills.

strong form efficiency

stock prices reflect all information, including information not available to the investment community.(ie trades of corporate managers and directors who clearly know more about firms prospects than the public)

semi strong form effiency

stock prices reflect all publicly available information. Implies stock prices react quickly to new info and prevents investors from earning abnormal returns.

Weak form efficiency

stock prices reflect the information contained in the history of past stock prices and trading volume. Implies daily stock price changes are independent; Useless to try to detect and exploit trends in stock prices.

valuation strategies

technical analysis: * stock prices driven by: psychology, technical, cosmic * how to value a share: trends, waves, factors * relationship b/w value and prices: p ≠ v fundamental analysis * stock prices driven by: earnings, dividends * how to value a share: forecast dividends, earnings * relationship b/w value and prices: p will eventually equal v portfolio theory * stock prices driven by: risk and return * how to value a share: risk and return * relationship b/w value and prices: p = v

Fixed rate discount bond

the bond is issued at a coupon rate that creates a market value of less than par at the time of pricing, and offering an yield that is higher than the coupon rate. popular in municipal bond market

fixed rate par bond

the issuer issues the bond at par value and pays fixed interest semi annually on predetermined dates and repays the full par value of the bond on maturity. most popular/most often used

fixed rate premium bond

the issuer will market a bond with a coupon and interest rate that creates a market value of more than par at the time of pricing, and an offering yield that is lower than the coupon rate

CAPM to evaluate investment performance

to evaluate performance, we must adjust for risk associated with portfolio - can't just look at returns. E(Rportfolio) = (Rf) + Bportfolio x [E(Rm) - (Rf)]