Finance Final
What are the primary factors that drive a firm's ROA?
Net profit margin and total assets turnover
Two basic components of the ROA:
ROA = NI / TA = (NI / Sales) ✕ (Sales / TA) NI / Sales = Net profit margin Its about profitability Sales / TA = TA total assets turnover Efficiency
___________ (coupon and principal payments) are contractual obligations of the bond issuer and are known by bondholders, since they are stated in the bond contract.
The cash flows
Most corporate bonds are issued with a face value of _______.
$1,000
cost-efficient:
(1) Index funds have lower management fees than actively-managed funds. a. .04% for index fund versus 1.4% for active funds (2) A buy-and-hold strategy saves you on transaction costs
Markets are efficient.
(1) Passive investors agree with the efficient market hypothesis (EMH). (2) Market prices adjust quickly to the new information as it becomes available. (3) Information is properly incorporated into stock prices.
tax-efficient:
(1) You defer the realization of capital gains, using a buy-and-hold strategy. As a result, you reduce capital gains taxes. (2) Example 11-5: Vanguard's S&P 500 Index fund paid no capital gains distribution for the 7th consecutive year.
Low transaction costs.
(1) low turnover (brokerage commissions) (2) low portfolio management fees (Low costs to operate)
An investor wrote (i.e., sold) one ABC $25 (exercise price is $25) call contract for a premium of $5 per share. If ABC stock price at expiration is $40, the buyer exercises his/her contracts. Which is the net profit/loss of this investment? Please assume that there are no transaction costs. a. $1000 b. $0 c. -$1000 d. -$500
(C) Ch 19: [5+ (25-40)]*100 = -1000.
CHANG Corp. has 5-year bonds outstanding that pay a coupon of 12.52 percent. Assume that these bonds are priced at $1083.76 and coupon payments are made semiannually. What is the annual yield to maturity on these bonds? a. 5.06% b. 5.17% c. 10.11% d. 10.33% e. 10.86%
(D) Ch 17: The solution is 5.17% on a semiannual basis, which by convention is doubled to obtain the annual YTM of 10.33%. A YTM calculated by annualizing in this manner is referred to as the bond-equivalent yield (Jones: p. 455).
Two types of stocks: growth stocks and value stocks
(a) Growth stocks: (1) Stocks that emphasize expectations about future growth in earnings. (2) Generally, growth stocks have high P/E ratios. (b) Value stocks: (1) Stocks whose prices are considered "cheap" relative to earnings, book value, and other measures thought indicative of value. (2) Generally, value stocks have low P/E ratios. (3) Value investing always involves finding bargains selling at prices below their actual economic value.
Other bond characteristics:
(a) If a bond is callable, the issuer (the firm issuing the bonds) can repurchase bonds prior to maturity. (b) Bond ratings indicate the relative probability of default risk.
The goal is to do as well as the market at minimum costs.
(a) Low transaction costs. (b) Low search costs (security analysis) (e.g., time spent in managing the portfolio) (c) The benefits expected from active trading are expected to be less than the costs.
What is the rationale behind active stock strategies?
(a) Market is inefficient. (b) Market inefficiencies provide exploitable opportunities of making excess returns.
Market timers attempt to stay in the stock market at the right times and move out of the stock market at the bad times.
(a) Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities. (b) They adjust when to carry a large cash position and when to shift their funds to stocks. (c) They increase their portfolio beta when the market is expected to rise.
1. What is the rationale behind passive stock strategies?
(a) Markets are efficient. (b) Investors cannot beat the market. (c) Passive investment management does not try to find undervalued stocks, nor does it try to time the market.
Two types of security analysts:
(a) Sell-side analyst: (1) Also called "Wall Street" analyst (2) Their research reports are used to "sell" an idea to all investors, both individuals and institutions. (b) Buy-side analyst: (1) Analysts employed by money management firms (such as pension funds, mutual funds, and investment advisers) (2) Their research is typically available to their employers.
The P/E ratio is positively related to the expected growth rate, g.
(a) The higher the expected growth rate, g, the higher the P/E ratio. (b) The higher the P/E ratio, the greater the market's expectations about future earnings growth.
Problems with Reported Earnings
1. EPS for a company is not a precise figure that is readily comparable over time or between companies. 2. Alternative accounting treatments used to prepare statements. 3. Difficult to gauge the 'true' performance of a company with any one method. 4. Investors must be aware of these problems.
Two types of Index Funds
1. Open-end index mutual fund: a mutual fund with an unfixed capitalization. Thus, the fund's capitalization is said to be open-ended. 2. ETF (Exchange-Traded fund): a mutual fund with a fixed capitalization whose shares trade on a stock exchange.
Security Selection
1. Two types of analysis: 2. Two types of stocks: growth stocks and value stocks 3. Two types of security analysts:
Active Stock Strategies
1. What is the rationale behind active stock strategies? 2. The goal is to beat the market. 3. Three components of the active approach to stock selection and management.
How many sectors are there in the S&P 500 index?
10
Market effects can account for ___ of the variability in a diversified portfolio's return.
90%
___________ movements remain the largest single factor explaining fluctuations in both individual stock prices and portfolios of stocks.
Aggregate market
P/E Ratio A measure of relative price of a stock.
The ratio indicates how much investors are willing to pay per dollar of earnings.
Is the interest expense on bonds tax-deductible for corporations?
Yes
Out-of-the-money call options have an exercise price that: a) exceeds the current market price of the underlying common stock. b) exceeds the strike price. c) is less than the current market price of the underlying common stock. d) is less than the strike price.
a) exceeds the current market price of the underlying common stock.
The __________ equates the present value of the total future dollars expected to be available at the end of a specific time period, given certain assumptions, to the price of the bond. a. horizon return b. promised return c. expected return d. coupon return
a. horizon return
Which of the following is TRUE regarding the risk premium? The risk premium a. must reflect all the uncertainty involved in the asset. b. does not apply to low beta stocks. c. is directly related to changes in the interest rate. d. reflects only the financial risk of a security.
a. must reflect all the uncertainty involved in the asset.
One percentage point of a bond yield represents: a. 1 basis point b. 10 basis points c. 100 basis points d. 1000 basis points
c. 100 basis points
EPS are of higher quality if: a. the company is a blue chip. b. the auditor's reputation is high. c. they were derived using conservative principles. d. FASB has approved them.
c. they were derived using conservative principles.
For adequately diversified common stock portfolios, market effects often account for -------- percent and more of the variability of the portfolio's return. a. 60 b. 70 c. 80 d. 90
d. 90
Coupons are paid to bondholders at a _________ annual coupon interest rate (rc).
fixed
The P/E ratio is ___________ related to the expected growth rate, g.
positively
Option exchanges are continuous primary and secondary markets.
The Chicago Board Options Exchange is the largest.
Who pays an option premium for buying each new contract in the primary market?
The buyers
Yield Spreads or Risk Premiums
The relationship between bond yields and the particular features on various bonds such as quality, callability, and taxes (a) Yield spread = Bond yield - Treasury yield
Who receives an option premium for selling each new contract in the primary market?
The writer
Writing a covered call is typically regarded as a _______________ because it reduces the cost of owing the stock.
conservative strategy
Bonds are used by _____________________ to raise large sums of capital.
corporations and governments
A stock is at $68. A two-month put (strike price = $70) is available at a $5 premium. The intrinsic value is _____ and the time value is ______. Please note that an option premium equals the sum of the intrinsic value and time value. a. $5 . . . $0. b. $0 . . . $5. c. $3 . . . $2. d. $2 . . . $3.
d. $2 . . . $3.
The longer the maturity of a security, the ___________ its interest rate risk.
higher
The lower the coupon of a bond, the _________ its interest rate risk.
higher
Bond yields move _________ to prices.
inversely
The yield spread varies ___________ to the business cycle.
inversely
The writer of a call is obligated to ______ the stock at the exercise price when the buyer exercises the right to buy the stock.
sell
A ________ who received option premiums in the primary market may be assigned to take action in the form of making or taking delivery of the stock.
writer
The term structure is usually plotted in the form of a __________.
yield curve.
Option contracts are a ___________ game before commissions and other transaction costs.
zero-sum
Options Market Which position is used to profit from the inherent riskiness of an underlying without investing in underlying assets?
Speculative position
Two steps to build a portfolio:
(a) Asset allocation. (b) Security selection.
Bond price (PB):
(a) Prices are quoted as a percentage of par value. (b) A $1,000-par-value bond is quoted at 94.007. What's the bond price? a. 940.07
Three components of the active approach to stock selection and management.
(a) Security selection (b) Sector analysis (c) Market timing
Investors purchase calls if they expect the stock price to rise.
(1) Calls permit investors to speculate on a increase in the price of the underlying stock without buying the stock itself. (2) Buyers of calls take a long position. (3) Because the call price and stock price will move together, an increase in stock price makes the call option more valuable. (4) The value of the call will increase as the stock price increases.
Yield spreads are a function of bond characteristics.
(1) Differences in quality (2) Differences in time to maturity (3) Differences in call features (4) Differences in coupon interests (5) Differences in marketability (6) Differences in tax treatments (7) Cross country differences
Passive investment management does not try to find undervalued stocks, nor does it try to time the market.
(1) No active strategy should be able to beat the market on a risk adjusted basis. (2) No attempt made to forecast market movements and act accordingly. (3) No attempt to select under- or overvalued securities.
Investors purchase puts if they expect the stock price to decrease.
(1) Puts allow investors to speculate on a decrease in the price of the underlying stock without selling the stock short. (2) Buyers of puts take a short position. (3) Because the put price and stock price will move inversely to each other, a decrease in stock price makes the put option more valuable. (4) The value of the put will increase as the stock price declines.
In-the-money (put options)
(1) The price of the underlying asset (S) < the exercise price of the option (E) (2) Intrinsic value (for the in-the-money put option) = E - S.
Out-of-the-money (Call Options)
(1) The price of the underlying asset (S) < the exercise price of the option (E) (2) Intrinsic value for the out-of-the money call option = 0. (No intrinsic value)
At-the-money (Call Options)
(1) The price of the underlying asset (S) = the exercise price of the option (E) (2) The exercise price is equal to the spot price of the underlying asset.
At-the-money (put options)
(1) The price of the underlying asset (S) = the exercise price of the option (E) (2) The exercise price is equal to the spot price of the underlying asset.
In-the-money (Call Options)
(1) The price of the underlying asset (S) > the exercise price of the option (E) (2) Intrinsic value for the in-the-money call option = S - E (Stock price - exercise price)_.
Out-of-the-money (put options)
(1) The price of the underlying asset (S) > the exercise price of the option (E) (2) Intrinsic value (for the out-of-the-money put option) = 0 = no intrinsic value.
ROE can also depend on the product of three variables:
(1) net profit margin (2) asset turnover (3) leverage.
In top-down, fundamental analysis, the first step is always to analyze: a. the economy b. the industry c. the company d. the particular security
(A) chapter 13, exhibit 13-1. a. the economy
A retention rate of 75% and a ROE of 16% implies sustainable growth of ___. a) 6.7%. b) 12%. c) 75%. d) 60%.
(B) Sustainable growth = Retention × ROE = 0.60 × 16% = 12%.
Find the price of a 10 percent coupon bond with three years to maturity if the yield to maturity is now 12 percent. Use semiannual discounting. a. $1196.70 b. $950.85 c. $952.20 d. $999.80
(B) Use 6 percent and 6 periods. Price = 50(4.917) + 1000(0.705) = $950.85.
CHANG Corp. has 5-year bonds outstanding that pay a coupon of 12.52 percent. Assume that these bonds are priced at $1083.76 and coupon payments are made semiannually. What is the current yield on these bonds? a. 5.06% b. 5.78% c. 10.11% d. 10.83% e. 11.55%
(E) Ch 17: 1000*12.52%/1083.76 = 11.55%.
How to figure out the semiannual coupon payment using the given information?
(Re x F) / 2
100th basis points are equal to one percentage.
(a) A basis point is a common unit of measure for interest rates and other percentages in finance. (b) One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
The value of a derivative security is derived from its connected underlying security.
(a) A derivative security is a financial instrument whose characteristics and value depend upon the characteristics and value of an underlying asset (underlie), typically a commodity, bond, equity or currency. (b) Examples of derivatives include futures and options.
ETF (Exchange-Traded fund): a mutual fund with a fixed capitalization whose shares trade on a stock exchange.
(a) A fixed number of shares trade on a stock exchange like individual stocks and close -end funds. (b) Shares can be bought and sold when the market is open. (c) The NAV and the share price don't usually diverge because of the arbitrage opportunity.
Option Strategies: Covered Covered positions involve hedges.
(a) A hedge is a combination of an option and its underlying stock. (1) The option protects the stock against loss (2) The stock protects the option against loss. (b) A hedge is a strategy using derivatives to offset or reduce the risk resulting from exposure to an underlying asset.
How to conduct a passive strategy?
(a) A passive investor can simply follow a buy-and-hold strategy. (b) An initial selection must be made to implement the strategy. (c) Investors have to perform certain functions while the buy-and-hold strategy is in existence.
A covered call involves the purchase of stock and the sale of a call on that stock.
(a) A strategy involves the writing of a call option to supplement a long position in an underlying asset. (b) A long position in the stock and a short position in a call. (c) This position is covered because the writer owns the stock and could deliver it if called to do so as a result the exercise of the call option by the holder.
The goal is to beat the market.
(a) Active investors attempt to exploit a whole variety of strategies with intention of outperforming index funds that simply buy and hold the broad stock-market portfolio. (b) They assume or expect the benefits to be greater than the costs. (c) Most investors favor this approach despite evidence about efficient markets.
General characteristics of futures and options contracts:
(a) Both have standardized features that allow them to be traded quickly and cheaply on organized exchanges. (b) The exchange guarantees the performance of these contracts. (c) A clearinghouse allows an investor to reverse his or her original position before maturity.
Five components of bond valuation:
(a) Coupon payments (C) = "PMT" key on your financial calculator (b) Face value (F) = "FV" key on your financial calculator (c) Discount rate (i) = periodic interest rate = required return on a bond (1) Determined by the market rate for similar-risk bonds. (2) This rate depends on the riskiness of the CF stream. (3) This rate also reflect investors' opportunity cost. (d) Relevant time period (n) = the # of periods to maturity = the # of compounding periods = the investment period (e) The price of the bond (PB) = "PV" key on your financial calculator
Option Strategies: Covered Two strategies:
(a) Covered calls (b) Protective puts
Bonds are viewed as long-term debt instruments that represent the issuer's contractual obligation.
(a) Debt instruments are also known as IOUs; IOU is an abbreviation, in phonetic terms, of "I owe you." (b) The buyer (bondholder) of a bond is lending money to the issuer who agrees to repay principal and interest. (c) Bonds usually have an initial maturity of 10 years or more. (d) Because bonds are debt instruments where the interest paid to investors is fixed for the life of the contract, they are called fixed-income securities. (e) Bonds can be viewed as fixed-cost financing securities for issuers (firms or governments) because of equal and periodic interest cost.
Potential benefits of derivatives:
(a) Derivatives allow investors to speculate, which involves taking a market position when a change in prices or interest rates is expected. (b) Derivatives contribute to market completeness. (c) Derivatives may serve as risk management tools.
Models:
(a) Dividend discount model (1) Zero growth (2) Constant growth (3) Variable growth (b) FCF model (c) An earnings multiplier model
The current yield measures the cash return for the year from the bond.
(a) Does the current yield measure the total return on your investment? a. NO (b) It ignores any change in bond value between the purchase and maturity. (c) This is not an accurate measure of total return, since it does not factor in capital gains.
What are three basic asset classes?
(a) Equities (b) Bonds (c) Cash equivalents
One approach to sector rotation is based on four broad sectors.
(a) Four broad sectors: (1) Interest-sensitive stocks, such as financial institutions. (2) Consumer durable stocks, such as Automotive, motor vehicles, electronics, tools and hardware, and homebuilding. (3) Capital goods stocks, such as manufacturing companies. (4) Defensive stocks, such as food production, soft drinks, beer, and pharmaceuticals. (b) Each of these sectors is expected to perform differently during the various phases of the business and credit cycles.
Two types of analysis:
(a) Fundamental security analysis: (1) The primary emphasis in fundamental security analysis in on expected EPS. (2) Rely on expected EPS or earnings estimates to justify stock selection. (b) Technical analysis:
The payoff to a put buyer:
(a) If S < E, the payoff is E - S. (b) If S > E, the payoff is 0. (c) In brief, a put option's payoff = Max [0, E - S] (d) The holder of a put faces a limited potential gain.
The payoff to a call buyer:
(a) If S > E, the payoff is S - E. (b) If S < E, the payoff is 0. (c) In brief, a call option's payoff = Max [0, S- E] (d) The holder of a call faces an unlimited potential gain.
An investor can establish a position with options for a much smaller investment than required with the security itself.
(a) If an option expires worthless, the most the buyer can lose is the cost (price) of the option. (b) Two types of position: (1) a hedged position and (2) a speculative position
A protective put offers some insurance against a decline in the stock price.
(a) If the price declines, option gains offset stock losses. (b) The cost if the insurance turns out not to be needed is the cost of the put.
Call Options Contracts: Preliminaries Three scenarios:
(a) In-the-money (b) At-the-money (c) Out-of-the-money
Put Options Contracts: Preliminaries Three scenarios:
(a) In-the-money (b) At-the-money (c) Out-of-the-money
The yield to maturity measures the average return on the bond over its life.
(a) Investors earn the YTM if (1) the bond is held to maturity and (2) all coupons are reinvested at the yield to maturity (YTM). (b) The YTM can be viewed as a promised yield because the stated conditions should be met.
Liquidity Preference Theory
(a) Long-term rates tend to be higher than short-term rates. (b) Support upward-sloping curves. (c) This theory states that interest rates reflect the sum of current and expected short rates, as in the expectations theory, plus liquidity (risk) premiums.
Bonds are used by corporations and governments to raise large sums of capital.
(a) Most of the large corporations, several thousand in total, issue corporate bonds to help finance their operations. (b) Many of firms have more than one issue outstanding.
The impact of the expected payout ratio on the P/E ratio is not clear cut. Why?
(a) On one hand, a higher payout ratio may have a positive impact on the P/E. (b) On the other hand, a higher payout ratio may lead to a decline in g, adversely affecting the P/E ratio.
At expiration, an option's payoff is simply the greater of $0 or the proceeds from the transaction.
(a) Option valuation is perhaps better understood by focusing on payoffs. (b) The profit takes into account the cost of the transaction.
Sellers of options = Option writers
(a) Options writers are betting the opposite of their respective purchasers. (b) A call writer expects the price of the underlying security to decrease. That is, the writer takes a short position in a call. (c) A put writer expects the price of the underlying security to increase.
(d) Coupons are paid semiannually in the U.S.
(annually in Europe) until maturity.
The option may expire worthless: 30%
(a) The call may expire worthless because the price of the stock did not climb enough to justify exercising the call. (b) The put may expire worthless because the price of the stock did not decline enough to justify exercising the put.
The exercise price is the per-share price at which the common stock may be purchased (in the case of a call) or sold to a writer (in the case of put).
(a) The exercise price (E) is also called the strike price. (b) Most stocks in the options market have options available at several different exercise prices, thereby providing investors with multiple alternatives.
Every option has an expiration date—the date an option expires.
(a) The expiration date is the last date at which an option can be exercised. (b) All puts and calls are designated by the date of expiration. (c) The expiration dates for options contracts vary from stock to stock but do not exceed 9 months for regular options (LEAPS have longer expiration dates).
Vanilla bonds, the most common bonds issued by corporations, have coupon payments that are fixed for the life of the bond. At maturity, the entire original principal is paid and the bonds are retired.
(a) The face value (F) of a bond will be repaid at maturity. (b) Coupon payments (C) on bonds are the interest payments (or cash payments) made to bondholders until maturity. (c) Coupons are paid for the life of the bond.
Market Segmentation Theory
(a) The market for loans is segmented on the basis of maturity. (b) The supply of and demand for loans within each segment determine its prevailing interest rate.
Expectations Theory: The yield curve reflects investors' expectations about future interest rates & inflation.
(a) The market rate for any period to maturity can be expressed as an average of the current rate and the applicable forward rates. (b) Forward rates are rates that are expected to prevail in the future.
Open-end index mutual fund: a mutual fund with an unfixed capitalization. Thus, the fund's capitalization is said to be open-ended.
(a) The number of shares outstanding of a mutual fund constantly changes—that is, it is open-ended. (b) The number of shares issued solely depends on investor demand. (c) Investors buy shares directly from investment companies and sell them back (i.e., redeem) (1) New shares are sold. (2) Outstanding shares are redeemed. (d) Do mutual funds trade on stock exchanges? a. No (e) Is there secondary market for mutual fund shares? a. No (f) Investors buy and sell shares every day at the NAV at the market close.
The option premium is the price paid by the option buyer to the writer (seller) of the option, whether put or call. That is, the buyer is charged an amount called the option premium.
(a) The premium is stated on a per share basis for options on organized exchanges. (b) Since the standard contract is for 100 shares, a $1.5 premium represents $150. (c) The option premium is often small, which might run a fraction of the current market price of the underlying stock. (d) A small investment can be "leveraged" into high profits (or losses). Thus, options provide one way to leverage one's investment to increase the potential rewards as well as the risks.
The premium is simply the market price of the contract as determined by investors.
(a) The price will fluctuate constantly, just as the price of the underlying common stock changes. (b) If an option expires worthless, the most the buyer can lose is the cost of the option.
Three factors affect the level and the shape (the slope) of the yield curve over time.
(a) The real rate of interest (b) The expected rate of inflation (c) Interest rate risk
The value of any asset is the present value of its future cash flows (CFs) over the relevant period.
(a) The value of a security is estimated by discounting its expected future stream of cash flows to the present and adding them together. (b) The estimated value of a security is equal to the present value of the future stream of cash flows that an investor expects to receive from the security. (c) This PV is what the asset is worth at a particular point in time.
Most corporate bonds are issued with a face value of $1,000
(a) This par value of a bond is assumed throughout this class, unless otherwise specified. (b) The face value is also known as (a.k.a.) the par value or principal amount. (c) At maturity, the par value is paid to the bondholder and the bonds are retired.
Fundamental Analysis Goal:
(a) To estimate the firm's intrinsic value. (b) To select under- or overvalued securities.
Types of corporate bonds:
(a) Typical bonds (b) Zero-coupon bonds (c) Convertible bonds that can be converted into shares of common stock at some predetermined ratio at the discretion of the bondholder.
Equity Options Quotations provide the following information:
(a) Underlying stock (b) Exercise price (or strike price) (c) Expiration date (d) Volume of contracts
DuPont System of Analysis A diagnostic tool that uses financial ratios to evaluate a company's financial health.
(a) Used to identify the primary driver(s) behind an increase or a decrease in the ROA (or ROE). (b) Decomposing the ROA (or ROE) into its components allows analysts to identify adverse impacts on the ROA (or ROE) and to predict future trends. (c) This analysis highlights expense control, asset utilization, and debt utilization.
Bonds benefit from a weak economy.
(a) When interest rates decline, bond prices increase. (b) The Fed tends to lower interest rates to stimulate economy.
Before maturity, an inverse relationship exists between PB and i.
(a) When interest rates go up, bonds go down in price. (b) When interest rates decrease, bond prices increase. (c) Owners of bonds will suffer a loss of capital because bond prices fall when yields rise. (d) Rising interest rates pose a risk for bond investors because when newer bonds are issued with higher coupons, the value of existing bonds with lower coupons declines as investors trade up. Fixed-income securities that are paying out at a lower interest rate than the prevailing interest rate of the day find themselves under pressure.
Two strategies to manage a portfolio:
(a) active approach (b) passive approach
5. What are the benefits of passive strategies?
(a) cost-efficient: (b) tax-efficient:
Two Types of Option Investors in the Primary Market
1. Buyers of options = Option holders 2. Sellers of options = Option writers 3. Options are created by writers (investors), and sold to buyers (other investors) in the primary market.
Measuring Bond Yields or Returns
1. Current Yield 2. Yield To Maturity (YTM) 3. Realized Compound Yield
Current Yield
1. The current yield measures the cash return for the year from the bond. 2. Formula: Current yield = (Annual interest payment)/(current price)
Writing Put Options:
1. The writer is betting that the price will not decline greatly, collecting premium income with no payoff. 2. The payoff for the buyer is the amount owed by the writer (payoff loss limited to the strike price since the stock's value cannot fall below zero)
Writing Call options
1. The writer is betting that the price will not increase greatly, collecting premium income with no payoff. 2. Writing call options can be a far riskier strategy than buying the same options. 3. The payoff for the buyer is the amount owed by the writer (no upper bound on E-S)
Characteristics of Zero-Coupon Bond 101
1. They are issued with no coupons to be paid during the life of the bond. 2. Zero-coupon bonds are sold at a large discount from the par value. 3. Zero-coupon bonds respond sharply to interest rate changes. 4. Firms that are expanding operations but have little cash on hand are especially likely to use zero coupon bonds for funding. 5. Zero-coupon bonds are attractive to investors who expect to lock in a fixed rate of return and eliminate reinvestment rate risk.
The option may be exercised by buyers:
10%
Equity Options A standard contract is designed for ____ shares of the underlying stock.
100
The option can be sold in the secondary market:
60% (a) How can option buyers close out their positions? a. Sell their options (b) How can option writers close out their positions? a. Buy the exact same options
What kind of relationship exists between the required return (R) and P/E ratio?
An inverse relationship exists between the required return and the P/E ratio
Accounting Aspects of Earnings from Financial Statements:
Balance Sheet Income Statement
How can option writers close out their positions?
Buy the exact same options
From an investor's viewpoint, why are bonds typically considered "safer" assets, at least relative to stocks and derivative securities?
Coupons and face value are fixed (a) Principal and interest are specified and the issuer must meet these obligations or face default, and possibly bankruptcy. (b) A bad year for a diversified portfolio of investment grade bonds looks like a mid-single-digit loss, as opposed to the average annual decline of 14% that the S&P 500 suffers in a down year (Source: Fortune.com, Oct. 1, 2015).
The P/E ratio is conceptually a function of three factors:
Dividend Payout Ratio Required rate of return Growth rate
What is the major factor affecting stock values?
Earnings per share (EPS)
Basic Options and Stock Positions: Uncovered: Buying put options writing put options
Expectation: decrease increase
Basic Options and Stock Positions: Uncovered: Buying call options Wiring call options
Expectation: increase decrease
Basic Options and Stock Positions: Uncovered: long position in a stock short position in a stock
Expectation: increase decrease
Options market Which type of position is used to offset the risk inherent in an underlying asset?
Hedge position
What kind of relationship exists between discount rates (i) and asset values (V0)?
Inverse relationship between discount rates and asset values (a) The low discount rate boosts all asset prices. (b) Asset valuations tend to fall ↓ after the hiking discount rates ↑.
_______-term bonds have more risk than ________-term bonds.
Long short
_________ -coupon bonds have more risk than _________ -coupon bonds.
Lower higher
Do option buyers have the ownership interest in the underlying asset?
No
In general, options on common stocks represent short-term claims on the underlying stock. Does the corporation whose common stock underlies these claims have direct interest in the transaction?
No
In general, options on common stocks represent short-term claims on the underlying stock. Is the underlying corporation responsible for creating, terminating, or executing put and call contracts?
No
Suppose David owns a put option with an exercise (strike) price of $30. If the stock price is $40, will he exercise the right?
No
The coupon rate is stated in the contact. Does it change as interest rates go up or down?
No
Buying Put Options:
Position taken in the expectation that the price will decrease.
Buying call options
Position taken in the expectation that the price will increase.
How to figure out the annual coupon payment using the given information?
Re x F
How can option buyers close out their positions?
Sell their options
Do long-term bonds have greater price volatility than short-term bonds?
Yes
Do lower-coupon bonds have greater price volatility than higher-coupon bonds?
Yes
Suppose David owns a put option with an exercise (strike) price of $30. If the stock price is $20, will he exercise the right?
Yes
The term structure of interest rates refers to the relationship between the ____________________ and ______________ for a particular category of bonds.
Yield to maturity (YTM) (or yields) interest rates
A protective put involves buying a stock (or owning it already) and a put for the same stock.
a) A strategy involves the purchase of a put option as a supplement to a long position in an underlying asset. b) The put acts as insurance against a decline in the underlying stock, guaranteeing an investor a minimum price at which the stock can be sold.
On a company's balance sheet, shareholder's equity is nearly always described by its? a. Book value b. Market value c. Current value d. Stock value
a. Book value
Which investment vehicle can be used to apply a buy-and-hold strategy?
a. Index funds
What are the top three sectors in terms of weighting?
a. Information technology b. Financial c. Healthcare
What are two determinants of a firm's EPS (Earnings per share)?
a. NI / Equity = ROE return on equity b. Equity / Shares = Book value per share
If the dividend growth rate increases for a firm, its P/E will ---------, other things the same. a. increase b. stay the same c. decrease d. increase or decrease but not stay the same
a. increase
In order to have a yield to maturity greater than the coupon rate, the bond must be: a. selling at a discount. b. selling at par. c. selling at a premium. d. a zero coupon bond.
a. selling at a discount.
Which of the following is true regarding option pricing: a. the longer the maturity of the option, the higher the premium. b. the more volatile the underlying stock, the lower the premium. c. option prices are less volatile than equity prices. d. the shorter the maturity of the option, the lower the premium.
a. the longer the maturity of the option, the higher the premium.
One important factor affecting the success of a market timing strategy is the _____________________________ with such a strategy as opposed to those paid with a buy-and-hold strategy.
amount of brokerage commissions and taxes paid
Investors shift sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better, and _____________ those sectors that are expected to do relatively worse.
avoid or deemphasize
The writer of a call option is said to have a: a) long position. b) short position. c) covered position. d) uncovered position.
b) short position.
An investor bought one ABC $25 (exercise price is $25) call contract for a premium of $5 per share. At the maturity (expiration), ABC stock price is $30. Which is the net profit/loss of this investment? a. $500 b. $0 c. -$500 d. $100
b. $0
Put and call options on equity securities are considered: a. Commodity derivatives b. Financial derivatives c. Forward contracts d. Futures contracts
b. Financial derivatives
Which of the following statements regarding changes in bond prices relative to changes in market yields is true? a. Short-term bond prices will increase more than long-term bond prices if market yields increase. b. Short-term bond prices will increase less than long-term bond prices if market yields decrease. c. Short-term bond prices will increase more than long-term bond prices if market yields decrease. d. Short-term bond prices will remain constant and long-term bond prices will increase if market yields decrease.
b. Short-term bond prices will increase less than long-term bond prices if market yields decrease.
Which of the following statements is true regarding a call writer: a. The call writer expects the stock to move upward. b. The call writer expects the stock to remain the same or move down. c. The call writer expects the stock to split. d. The call writer expects to sell the stock prior to expiration of the option.
b. The call writer expects the stock to remain the same or move down.
An analyst employed by a pension fund to search for stocks for the fund to invest in would be referred to as: a. a sell-side analyst. b. a buy-side analyst. c. an institutional analyst. d. a money manager.
b. a buy-side analyst.
Which of the following represents the rate at which a company can grow from internal sources? a. return on assets b. sustainable growth rate c. adjusted EPS d. return on equity
b. sustainable growth rate
The yield to maturity consists solely of interest income if: a. the bond is a zero coupon bond. b. the bond was purchased at par. c. the bond was purchased above par. d. the bond was purchased below par.
b. the bond was purchased at par.
A call option on a stock gives the buyer the right to _____ 100 shares of particular common stock at a specified price any time prior to a specified expiration date.
buy
The writer of a put is obligated to ______ the stock at the exercise price when the buyer exercises the right to sell.
buy
With an upward sloping yield curve, which of the following maturities will have the highest yield? a. 5-year. b. 10-year. c. 30-year. d. 90-day.
c. 30-year.
Which of the following statements about bond prices is FALSE? a. Bond price volatility and time to maturity are directly related. b. A decrease in yields raises prices more than an increase in yields lowers prices. c. Bond price fluctuations and bond coupons are directly related. d. Bond prices move inversely to bond yields.
c. Bond price fluctuations and bond coupons are directly related.
One important reason for the existence of derivatives is that they: a. help lower transactions costs. b. have valuable tax benefits. c. contribute to market completeness. d. are risk-free.
c. contribute to market completeness.
Historically, sell-side equity research has typically been _________to the target company? a. very unfavorable b. unfavorable c. favorable d. neutral
c. favorable
The central focus of a security analyst's job is to: a. ascertain the accuracy of financial statements of selected companies. b. find growth stocks. c. forecast a specific company's return. d. determine the market demand for a specific company's stock.
c. forecast a specific company's return.
If the price of the common stock exceeds the exercise price of a call for the holder of the call option is said to be a. naked. b. out of the money. c. in the money. d. covered.
c. in the money.
The YTM calculation assumes: a. reinvestment of interest is at the coupon rate. b. no reinvestment of interest. c. reinvestment of interest is at YTM rate. d. reinvestment of interest is at the risk-free rate.
c. reinvestment of interest is at YTM rate.
An increase in reinvestment rate risk a. is caused by an increase in interest rates. b. leads to a decline in coupon rates. c. results from a decline in interest rates. d. results from an increase in inflation.
c. results from a decline in interest rates.
If a bond is callable, this means: a. the issuer may change the coupon rate. b. the investor may convert the bond into stock. c. the issuer may redeem the bond early. d. the investor may cash in the bond at any time.
c. the issuer may redeem the bond early.
A major difference between new shares being sold by a corporation and shares sold under a call option is that: a. there is no profit or loss under the shares sold under the call. b. there is no risk to the investor with the call. c. there is no increase in the shares outstanding with the call. d. there is no commission to the investor with the call.
c. there is no increase in the shares outstanding with the call.
Maturity and coupon being equal, which of the following bonds will have the highest yield to maturity? a. Treasury bond. b. AAA- rated corporate bond. c. BBB+ rated corporate bond. d. BB- rated corporate bond.
d. BB- rated corporate bond.
____________ funds are especially popular with momentum investors. a. Index. b. Managed c. Global d. Sector
d. Sector
Which of the following statements regarding defensive stocks is true? a. They are often expected to have above-average future growth. b. They often have high P/E multiples. c. They are expected to be adversely affected by high interest rates. d. They often produce necessary items such as food and prescription drugs.
d. They often produce necessary items such as food and prescription drugs.
If security markets are totally efficient, the best common stock strategy to take is: a. an asset allocation approach. b. the modern portfolio theory. c. an active strategy. d. a passive strategy.
d. a passive strategy.
Which of the following variables has an inverse relationship with the P/E ratio? a. payout ratio b. expected growth rate of dividends c. expected growth rate of earnings d. required rate of return
d. required rate of return
If the bond yield is greater than its coupon rate, the bond price < the face value. Then, this bond trades at a ___________.
discount
Standardized contracts:
exercise dates, exercise prices, and quantities.
If the current market price = its estimated intrinsic value, the asset is ____________ valued.
fairly (correctly)
Options provide ___________—the chance to magnify percentage gains.
leverage
Bonds are viewed as _____-term debt instruments that represent the issuer's contractual obligation.
long
If the current market price of a security > its estimated intrinsic value, the asset is ___________. Thus, investors will ______ this security.
overvalued sell
Common stock represents the _____________ in a corporation, providing voting rights, and entitling the holder to a share of the company's success through dividends and/or capital appreciation.
ownership interest
If the bond yield is lower than its coupon rate, the bond price > the face value. Then, this bond trades at a __________.
premium
The value of any asset is the __________ of its future cash flows (CFs) over the relevant period.
present value
The _____________________ is the yield earned on a bond based on actual reinvestment rates during the life of the bond.
realized compound yield (RCY)
Option contracts give the buyer the _______ to buy or sell a stated number of shares of the underlying security at a stated price (also called the exercise price) within a specified period.
right
Once the option is created in the primary market, it can be traded repeatedly between buyers and sellers in the ____________.
secondary market.
A put option on a stock gives the buyer the right to ______ 100 shares of particular common stock at a specified price any time prior to a specified expiration date.
sell
options on common stocks represent ________-term claims on the underlying stock.
short
Options are _______________ claims on a stock as an _____________ to invest.
short-term / indirect alternative way
The size of the yield spread changes over time. Whenever the differences in yield become __________, the yield spread is said to "narrow"; as the differences __________, it "widens."
smaller increase
If the current market price of a security < its estimated intrinsic value, this asset is _____________. Thus, investors will _____ this security.
undervalued buy
