midterm
What is a portfolio?
A portfolio is a group of assets owned by an investor. Practice again
What is a bond's yield to maturity (YTM)?
The return you'll earn if you hold the bond to maturity and yields stay the same The YTM equals the return for an investor who buys the bond today, holds it until maturity and is able to reinvest all coupons at the current yield. In an efficient market, expected returns must be the same for similar securities. Therefore, the YTM can also be interpreted as the market interest rate for similar bonds.
Which is NOT a right of common stockholders?
The right to receive regular dividends Common shareholders are not entitled to regular dividends. Dividend payments are at the discretion of the board of directors.
Which are rights of common stockholders?
The right to vote on major decisions at the annual general meeting The right to a share of dividends paid The right to vote for members of the board of directors ____________ Common shareholders are not entitled to regular dividends. Dividend payments are at the discretion of the board of directors.
Dividend yield increases as
The stock price decreases Dividend yield equals the ratio of dividends per share over the stock price (D/P), so a lower stock price implies a higher dividend yield.
Why would an investor buy an unsecured corporate bond instead of a comparable secured corporate bond?
The unsecured bond offers a higher yield to maturity. The unsecured bond is riskier than a secured bond. To compensate investors for the greater risk of default, the company offers a higher yield to maturity.
The real risk-free interest rate is expected to remain constant, inflation is expected to rise steadily, and the maturity risk premium (is expected to be 0.2T%, where T is the number of years until the bond matures. Which of the following statements is correct?
The yield curve is upward sloping. The yield curve is upward sloping, since both the inflation premium and the maturity risk premium increase with time to maturity.
Municipal bonds are different from corporate and treasury bonds in that
They are exempt from federal taxes Interest income from munis is always exempt from federal taxes, and sometimes also exempt from state taxes in the state they were issued in.
Why do bonds with lower seniority have higher yields to maturity than comparable bonds with higher seniority?
To compensate investors for greater default risk. Lower seniority means lower priority in the case of bankruptcy, thus increasing the risk of default.
Is a callable bond more valuable to the issuer or the bondholder than a comparable straight bond and why?
To the issuer, since the issuer can refund (pay off) the bond when interest rates have fallen When a bond is callable, the issuer can refund (pay off) the bond when interest rates have fallen and issue a new bond with a lower interest rate, thus saving money.
What has maturities up to one year?
Treasury Bills
What has maturities greater than 10 years?
Treasury Bonds
What are valid approaches for valuing a share of stock?
Valuation by comparables Valuation by discounting free cash flows Valuation by discounting dividends _________ We can value a share of stock by comparing certain financial ratios, such as the P/E ratio, and by discounting dividends or free cash flows.
The slope of the security market line equals the
Market Risk Premium
Time to maturity means
The length of time until the repayment of the principal the maturity date is the date when bondholders receive the last coupon payment as well as the principal (par or face value).
Treasury bonds are different from corporate and treasury bonds in that
They are exempt from local taxes
The capital gains yield is the
percentage change in the stock price Capital gains yield is defined as (P1-P0)/P0.
Treasury bills are assumed to have a beta of
0 Treasury bills are commonly assumed to be risk-free, implying a beta of zero.
The beta of the market portfolio is
1 The beta of the market portfolio is 1. Beta is the slope of the regression line. The slope is necessarily 1 if we regress the (excess) return onf the market portfolio on the (excess) return of the market portfolio.
If California issues a bond, what is it called?
A municipality bond
What bond rating has the lowest risk of default?
AAA AAA is the highest (most secure) bond rating, followed by AA, A, BBB, BB, B, C and D.
Which are two other words for par value?
Amount to be repaid on the maturity date Face value Par value NOT A WORD: Price The price of a bond fluctuates over time, while the face value or par value is fixed and represents the amount to be repaid on the maturity date of the bond.
Diversification works if
Assets are imperfectly correlated Diversification works if assets are imperfectly correlated, i.e., diversification reduces portfolio risk (standard deviation) if the correlation between assets in the portfolio is less than one.
Between an A grade and B grade bond, what has a higher default risk?
B has a higher risk
What is the highest grade that is considered speculative or junk?
BB
What is the lowest grade that is considered investment grade?
BBB Bonds with a rating of AAA, AA, A or BBB are considered investment grade, while lower rated bonds are considered speculative grade or junk bonds. Practice again
What is true about common stocks?
Common stock is an ownership share in a corporation. Stockholders have limited liability: the most they can lose in the event of failure of the corporation is their original investment. Stockholders are the last in line of all those who have a claim on the assets or income of the corporation (residual claim). _______________________ Dividend payments are the discretion of the board of directors and can be suspended temporarily or indefinitely.
Corporate bonds have higher yields than comparable treasury bonds because
Corporate bonds have a default risk A corporation can default on its obligation to repay interest and principal, while the federal government can always print more money to meet its obligations
What bond rating has the highest risk of default?
D
As different securities are added to a portfolio, the portfolio's total risk
Decreases The benefit of diversification is that total risk falls as more and more different securities are added to a portfolio, up to the point where all diversifiable risk is eliminated and only market risk remains.
Which is not a factor shaping the Treasury yield curve?
Default risk Treasuries have no risk of default, since the government could always print more money to meet its bond obligations. Therefore, default risk is not reflected in the Treasury yield curve.
What are common risk premiums?
Default risk premium Liquidity premium Term (maturity risk) premium _____________ Nominal rate = real rate + inflation premium + risk premium Risk premiums: Default risk premium: return component to compensate investors for the risk that the issuer will not pay the promised interest or principal Liquidity premium: return component to compensate investors for the risk that some assets cannot be sold (converted to cash) at a fair price on short notice Maturity risk premium: return component to compensate investors for the risk that increases in market interest rates will lead to large price drops for existing debt securities. The longer the time to maturity, the greater the interest rate (or price) risk.
The constant growth model is based on the assumption that
Dividends grow at a constant rate It assumes that dividends grow at some constant rate g every period, such that Dt = Dt-1 (1+g).
In general, an asset with a higher expected return
Has a higher risk The risk-return trade-off implies that a higher expected return goes hand-in-hand with higher risk.
The risk an investor faces if he/she holds only one asset is called
Stand-alone risk Stand-alone risk is the risk an investor would face if the investor held only a single asset. In reality, however, most assets are held in portfolios.
If expected inflation increases
Interest rates are likely to increase If expected inflation increases, interest rates are likely to increase, as new investors want to be compensated for the erosion of purchasing power.
Which is true about a bond's par value
It's equal to the market price of the bond The clean price is the market price of the bond and fluctuates as interest rates and time to maturity change, while the par value is constant (typically $1,000 for corporate bonds).
What increases price risk?
Low coupon rates and long time to maturity
Securities with prices that move less than the market average have what kind of betas?
Lower betas (generally between 0 and 1) Securities whose prices move less than the market have lower betas, i.e., betas between 0 and 1.
What does diversification do?
Lowers overall portfolio risk by lowering specific risks Diversification is the mixing of different assets within a portfolio. It reduces overall portfolio risk
Which of the following events would make it more likely that a company would call a callable bond?
Market interest rates decrease significantly. If market interest rates fall significantly, the company can issue new bonds at much lower interest rates. It is therefore in the interest of the company to pay off the old, high-interest bonds and replace them with new, low-interest bonds. Practice again
What is diversification?
Mixing different assets in a portfolio
Which is not a source of expected returns in the dividend discount model?
Most recent divident E(r) = D1/P + g, where D1/P is the expected dividend yield and g is the growth rate of both dividends and the share price, thus reflecting the expected capital gain. The most recent dividend, D0, is not a source of expected return.
Common stockholders can expect _____ dividends and _______ capital gains.
Neither dividends nor capital gains are certain.
What are determinants of market interest rates?
Real rate of interest Inflation premium Risk premium _______________ Nominal rate = real rate + inflation premium + risk premium Real rate of interest: The interest rate on a risk-free security in a world without inflation (not directly observable) Inflation premium: return component to compensate investors for the erosion of purchasing power due to inflation Risk premium: return component to compensate investors for various risks, such as default or limited liquidity
Which factors shape the Treasury yield curve?
Real rate of interest Expected inflation Interest rate risk Treasuries have no risk of default, since the government could always print more money to meet its obligations. Therefore, default risk is not reflected in the Treasury yield curve.
The graphical representation of the CAPM is called the
Security Market Line (SML) The security market line (SML) shows the relationship between a security's beta and its expected return, as does the CAPM.
The executive board comprises the top managers of a company: CEO, CFO, COO, CMO, etc. Which statements are true?
Shareholders elect the board of directors. The board of directors appoints and monitors the executive board. The board of directors has a fiduciary duty to shareholders. __________ There are too many shareholders to effectively supervise the executive board. That is why shareholders elect a board of directors to supervise the top managers on their behalf.
What do you call an escrow account into which the bond issuer makes regular payments?
Sinking Fund A sinking fund is an escrow account into which the bond issuer makes regular payments to retire the debt over time, thus decreasing the risk of default on the maturity date.
Diversification can eliminate what kind of risk?
Specific or unsystematic risk Diversification can eliminate diversifiable risk, but not market risk.
We measure the risk of a single asset or portfolio by measuring the
Standard deviation of its returns The risk of a single asset, i.e., one not held as part of a portfolio, is measured by the standard deviation of returns. We use standard deviation because the risk is to earn a lower return than the expected return asset returns roughly follow a normal distribution the normal distribution is symmetrical standard deviation tells us how dispersed the distribution of returns is around its mean, allowing us to calculate the probability with which a return will be significantly lower (or higher) than the expected return.
As different securities are added to a portfolio, market risk will
Stay the same. Diversification can't lower market risk by nature Market risk is also called non-diversifiable risk for a reason: it cannot be reduced or eliminated by diversification.
Is the YTM lower or higher than the coupon rate for a premium bond?
The YTM is lower A premium bond trades above par value. The fact that new investors are willing to accept a capital loss as the price converges to par value over time implies that the coupon rate must be larger than the market interest rate (the YTM).
What happens when a bond's yield to maturity increases
The price falls If a bond's yield to maturity increases, its price will fall, and vice versa. Yields and prices have an inverse relationship.
Which piece of information is always unnecessary to find the intrinsic value of a stock using P/E ratios?
The company's current stock price P = P/E * E, so we need a relevant P/E benchmark, either from the company's own history or from similar companies, and the most recent or expected earnings per share. The stock price is the result of the calculation, not an input.
Which is NOT a factor making stock valuation more difficult than bond valuation?
The discount rate is unobservable Stocks have no maturity date, and future dividends and the stock price are uncertain, while bonds have a maturity date and their interest payment and face value are known. However, the discount rate is unobservable for both stocks and bonds.
Stock A's beta is 1.7 and Stock B's beta is 0.6. If the CAPM holds, which of the following statements is correct?
The expected return on stock A is greater than that on B According to the CAPM, expected return depends only on one characteristic of a stock, its beta. Stocks with higher beta have more systematic risk: to compensate investors for the higher risk, they must offer a higher expected return.
The P/E ratio measures
The price an investor pays for $1 of earnings The P/E ratio is defined as the ratio of stock price over earnings per share (P/EPS). As such, it shows how much money a stock investor has to pay for each dollar of earnings per share. Higher P/E ratios are typically associated with faster expected growth in earnings per share.
What happens to the price of a bond with a 5% coupon rate if interest rates for similar bonds go up to 8%?
The price decreases because the present value of future payment decreases Higher interest rates (bond yields) mean a higher discount rate, so that the present values of future coupons and of the face value are reduced.
The real rate of interest equals
the nominal interest rate adjusted for inflation The real rate is a function of the nominal rate and the expected inflation rate.
The term structure of interest rates refers to the relationship between
a bond's time to maturity and its yield Typically, bonds with longer times to maturity have higher yields, giving rise to an upward-sloping yield curve. The yield curve is the graphical representation of the term structure of interest rates.
Price risk is the risk that
a bond's value decreases when interest rates increase
A capital gains yield of zero implies
a zero growth rate of dividends In the dividend discount model, the stock price appreciates at the same rate as dividends. A capital gains yield of zero means a constant stock price, which is only possible if the growth rate of dividends is zero.
The claim that preferred shareholders have on the assets and income of a firm is _____ that of creditors and _____ that of common shareholders
below; above Preferred stock is similar to debt in some respects and similar to common stock in others, and lies between the two from a finance perspective. In terms of claim on assets of a firm, creditors are at the top, followed by preferred stock holders, with common stock holders coming after the two.
A callable bond is a bond that
can be repurchased by the issuer before the maturity date A callable bond is a bond that can be repurchased by the issuer before the maturity date. The price at which the bond can be repurchased is the call price, which is usually above the par value. The difference between the call price and the par value is the call premium. A bond issuer has an incentive to call a bond if market interest rates have fallen significantly since the issue date, allowing the issuer to issue a new bond with a lower coupon rate and paying off the old bond.
The main risk of owning treasury bonds is the risk of
changing market interest rates If market interest rates go up, the price of bonds falls. Treasury bonds have no risk of default and coupon rates are fixed once a bond has been issued. Treasury bonds are the most liquid security of all, even in a financial crisis.
When market interest rates (ie yields) increase, the price of existing bonds
decreases Since the yield to maturity is the rate used to discount all future payments from a bond, rising yields lead to lower present values and thus a lower bond price. Alternatively, a rise in market interest rates makes existing bonds with fixed coupon rates less attractive, thus leading to lower prices.
When market interest rates (or yields) increase, the price of existing bonds
decreases Since the yield to maturity is the rate used to discount all future payments from a bond, rising yields lead to lower present values and thus a lower bond price. Alternatively, a rise in market interest rates makes existing bonds with fixed coupon rates less attractive, thus leading to lower prices.
Preferred stockholders have preference over common stockholders
in the payment of dividends and the distribution of liquidation value Preferred stockholders must receive their promised dividend before any dividends can be paid to common stockholders. Similarly, if the company goes out of business and its remaining assets are liquidated (sold), preferred stockholders receive money first, while common stockholders receive a share only if any money is left over.
A zero-coupon bond is a bond that
is issued at a discount and makes no interest payments Zero-coupon bonds, or zeros, are issued at a discount to par value and make no interest payments. Interest is earned from the difference between the discounted issue price and the par value received at maturity.
Bonds are
less costly than bank loans for the borrower interest-only loans issued by governments or corporations BONDS ARE NOT: riskier than stocks Stocks are riskier than bonds, since stock prices are more volatile than bond prices and bondholders have precedence over stockholders in the case of bankruptcy.
Preferred stock is like long-term debt since both _____, but preferred stock also resembles equity since both _____.
make regular, fixed payments; don't guarantee dividend payments Preferred stock is like long-term debt since both make regular, fixed payments, but preferred stock also resembles equity since both don't guarantee dividend payments (the board of directors can decide not to pay dividends indefinitely) and any dividend payments are not tax-deductible by the firm (unlike interest payments on bonds).
The non-constant growth dividend discount model is most appropriate for companies that are
new New companies, such as startups, often grow very quickly initially before their business matures and their growth rate settles down to a value that is approximately constant.
A yield curve where yields on longer-term bonds are always higher than yields on shorter-term bonds is called what kind of curve
normal A normal yield curve is upward sloping, i.e., yields on longer-term bonds are higher than yields on shorter-term bonds. The reason we typically see normal yield curves is that bonds with longer time to maturity have more interest rate (or price) risk, thus having to compensate investors with higher yields.
A yield curve where yields on longer-term bonds are always higher than yields on shorter-term bonds is called what type of curve
normal A normal yield curve is upward sloping, i.e., yields on longer-term bonds are higher than yields on shorter-term bonds. The reason we typically see normal yield curves is that bonds with longer time to maturity have more interest rate (or price) risk, thus having to compensate investors with higher yields.
The difference between bonds and stocks is that
only stocks grant an ownership stake in the company only stockholders can vote in annual company meetings only bondholders can sue a company for missing a payment SIMILAR: Both have limited downside risk both stocks and bonds have limited downside risk: the most a bond or stock investor can lose is the amount invested. However, bonds have a limited upside potential, while the return to shareholders is theoretically unbound on the positive side.
The nominal interest rate is also called the
quoted interest rate The nominal interest rate is also called the quoted interest rate. Listed, or quoted, interest rates are always nominal (as opposed to real) rates, unless explicitely noted otherwise.
Municipal bonds are issued by
state and local governments
Beta measures the
systematic or market risk of a stock Beta is an indication of the systematic risk of a stock: the higher the beta, the more systematic risk the stock has.
The risk premium is
the reward for bearing risk normally positive for risky assets the difference between the expected rate of return on an asset and the risk-free rate __________________________________________ The risk premium compensate investors for bearing risk. An additional return of zero would be no compensation.
The dividend yield increases as
the stock price decreases Dividend yield equals the ratio of dividends per share over the stock price (D/P), so a lower stock price implies a higher dividend yield.
A discount bond is a bond
whose price is less than par value a discount bond trades at a discount to par value. Its price must therefore increase as the maturity date approaches. The price of any bond, including discount bonds, typically reflects its fair market value.