Consumer Finance Midterm 1 and 2
Income statement (Cash flow statement)
"cash flow statement" Tells you where your money has come from and where it has gone over some period of time - Includes income and expenditures (net income) - Gives a "moving picture", Tells you what you have to work with - Considers taxes - Cash basis = based on actual cash flows Income - Expenses (over a time period) - If your take-home pay is greater than your living expenses, you can save and invest. BUT if your take-home pay is less than your living expenses, you've got some changes to make
Income
"cash inflows" - Wages, salary, bonuses, tips, commissions before tax, investments - Subtract federal, state, social security taxes from earnings to calculate your take-home pay
Balance sheet (Net Worth Statement)
"net worth statement" - Used to measure wealth - A snapshot of financial status at a particular time Combines (Own and Owe): 1) Assets currently owned (what you own) 2) Debt or liabilities incurred (what you owe) - Result is "net worth" or "equity" Net worth = total assets - total debt - Liabilities > assets = negative net worth and insolvent - Liabilities < assets = positive net worth NET WORTH IS A "SNAP SHOT" BECAUSE IT DOES NOT CONSIDER TAXES
Annuities
"regular investments over periods in the future" Series of equal dollar payments at the end of each time period for a specific number of time periods EX: Pension funds, insurance obligations, and interest received from bonds - An equal dollar periodic payment of investment earnings or paying off installment loans Compound annuity = depositing an equal sum of money at the end of each year for a certain number of years, allowing it to grow - When to use: You want to know how much your savings will have grown by some point in the future. (Education, a new car, or any time you want to know how much your savings will have grown by some point in the future.) - How to use: Sum up a number of future values
Annual rate of return formula
( [($ ending value - $ purchase price) + $ income] / $purchase price ) X 1/N
How do mutual funds work (on a high level); pooling of money to purchase
- As the value of the securities in the fund increases, the value of each mutual fund share also rises. - Dividends or interest also goes to shareholders. - Shareholders receive a capital gains distribution when the fund sells a security for more than originally paid.
How to shop for and manage credit card borrowing
- Different cards have different strong points. Find one that fits your needs. - Different credit cards charge different APRs and calculate the finance charges imposed in different ways - Reducing your balance by understanding your initial balance and the interest rate of your credit card - Protecting against fraud by not giving out your number and keeping receipts and disposing of them properly - Identify spending habits and troubles - Place a budget on yourself and work on self-control
Load vs no-load funds; how do Class A share work?
- Load = commission charged on a mutual fund - Load fund = mutual fund on which a load is charged - Class A shares = front-end sales load No-load fund = doesn't charge commission
Budgeting and managing spending
- Provide resources to set aside for savings, investments, major purchases, or debt reduction - Financial ratios allow you analyze raw data in the balance sheet or income statement then compare it to targets. These are guidelines, not rules. They help understand how financial resources are being managed. - Effective saving is by paying yourself first - Record keeping: track your financial dealings and file and store your records - Evaluate your financial health by using balance sheet and income statement - Develop a plan of action and cash budget using the income statement - Control cash inflows and outflows
Fluctuation of bond prices
1) Inverse relationship between price and current interest rate environment in the secondary market - When rates go up, bond values go down. 2) Bonds with longer maturations fluctuate more when rates change 3) As a bond approaches maturity, the market value approaches its par value - If the issuer becomes riskier, the required rate of return should rise - A change in general interest rates, the required rate of return should increase. - When interest rates rise, the value of outstanding bonds falls - When interest rates drop, bond values rise
Categories of mutual funds (money market, stock, bond, sector, growth, index, international, balanced, asset allocation, life-cycle)
1) Stock Mutual funds: Consist of a combination of - Aggressive growth funds - Small company growth funds - Growth funds - Growth-and-income funds - Sector funds - Index funds - International funds *It diversifies itself!* 2) Balanced Mutual funds: - Holds both common stock and bonds (Sometimes holds preferred stock as well) - Aimed at those needing income to live on and moderate stability in their investments. - Less volatile than all stock mutual funds Asset Allocation funds: - Invest in stocks, bonds, and money market securities. - Moves money between stocks and bonds to outperform the market - Balanced funds that practice market timing - Seek to maintain specific allocation mix 3) Retirement Mutual funds: (life cycle and target date) - Try to tailor their holdings to the investor's individual characteristics, such as age and risk - Target retirement funds are managed based on when you plan to retire 4) Bond Mutual funds: - Mutual funds that invest primarily in bonds. - Fluctuate in value with market interest rates - Used to keep small amounts of money liquid (Or use individual bonds where there is no professional management or fees) - Types = U.S. Government Bond, Municipal Bond Funds, Corporate Bond Funds, and International
3) Explain the differences between mutual funds & ETFs.
1)How they trade Mutual funds: - Prices are determined once a day after the market closes - All orders are processed after the market closes based upon the price at close ETFs: - Traded continuously throughout the day - Price based upon supply and demand" 2) Mutual funds have more assets and net inflows 3) Trading Costs and Fees Mutual funds: - "No commission if purchased directly from the company - Load funds purchased through a broker have an average annual expense of 0.98% ETFs: - Brokerage commission paid where the ETF is bought or sold. - The average annual expense is 0.56% but can add up quickly 4) Holdings Transparency Mutual funds: - Reported monthly or quarterly ETFs: - Reported daily
Deposit insurance
2 Federal agencies: NCUA = deposits at credit unions FDIC = deposits at commercial banks - Federally insured! Why is it important? - Protects against failure of the institution - Depositors protected, not accounts
Yield to Maturity calculations using TVM
A bond has 10 yrs left to maturity w/a current price of $880 and coupon rate of 10%. What is the YTM? N=10 PV = -880 PMT = 100 FV = $1000 Solve for I = 12.14%
Indenture
A legal document that provides specific terms of the loan agreement Includes: - A description of the bond including par value, coupon rate, length of the bond - The rights of bondholders to get paid the stated interest - The rights of the issuing firm - The responsibilities of the bond trustees
Efficient Markets
A market in which information about the stock is reflected in the stock price - The more efficient the market, the faster prices react to new information - If the stock market were truly efficient, then there would be no benefit from stock analysts Very hard to beat the average consistently - Half the time you should outperform the market, and half the time you should underperform - Difficult for "superstars" of investing to pick underpriced stocks and time the market - Invest long term
5) Differentiate between active & passive investing, particularly as it relates to mutual funds. What are the implications for investors?
Active = have a portfolio manager(s) making buy/ sell decisions - May utilize fundamental and/or technical analysis Passive = follow an index (ex: S&P 500) and make few changes - Buy the market or a segment of the market
Advantages & disadvantages of investing in mutual funds
Advantages: - Professional management - Minimal transaction costs - Liquidity and flexibility - Service - Easy to include in plan - Instant diversification within fund - Fund "supermarkets" - Can be bought without sales charge if investor desires Disadvantages: - Lower than market performance - Possible sales charges - Annual management fees (0.5% - 3%) - Annual administrative charges ($5 - $25 per account) - No control over taxes - No control over specific details of investment - Risks - You can't diversify away market cash
Preferred stock
Alternative to bonds; A hybrid security with features of common stock and bonds - Similar to common stock—no fixed maturity date, not paying dividends won't bring bankruptcy - Similar to bonds—dividends are fixed, paid before common stock and no voting rights - The value of a share of preferred stock is the present value of the perpetual stream of constant dividends Risks: - If interest rates rise, the value of preferred stock drops - If interest rates drop, the value of preferred stock rises and it is called away Advantages: - Income relatively certain - Typically paid quarterly (paid before common) - The investor's capital is relatively secure—priority for profits and liquidation - Prices more stable than common stocks - Some preferred stocks are "convertible." Disadvantages: - Dividend purchasing power may erode with inflation - Dividend payments usually fixed (Some preferred stocks are "participating" issues) - Less opportunity for capital growth
Calculate the annual interest on a bond
Always use par value to calculate A bond with a 5% coupon pays out $1000 x 0.05 = $50
Perpetuity
An annuity that continues to pay forever - Every year this investment pays the same dollar amount and never stops paying Formula: PV = PP / i - PP = the annual dollar amount provided by the perpetuity - i = annual interest rate
Mutual fund
An investment that raises money from investors, pools the money, and invests it in stocks, bonds, and other investments - Each investor owns a share of the fund proportionate to his/her investment - Investors are pooled with similar financial goals
What does APR stand for? Why is it important?
Annual Percentage Rate - The true "simple interest rate" paid over the life of the loan - Calculated same way but what varies is what is included - APR for all consumer loans must be disclosed (Truth in Lending Act) - Main factor that determines the cost of a line of credit Importance: - While there can be differences in what's included in it, it's calculated the same way by all lenders, and the federal Truth in Lending act requires that all consumer loan agreements disclose the APR in bold
Assets
Anything that you own, have title to, or have an unchallenged right to use - Can be physical property (EX: house, land, car) or intangible property (EX: stocks, mutual funds, royalties) - They are your possessions, include even if you owe money on them - Always use "fair market value" - All value must be current (need to account for appreciation and depreciation) Types: - Monetary (cash, checking, savings) - Investment (stocks, bonds, mutual funds) - Retirement (IRAs, 401(k)) - Housing (primary residence, vacation) - Automobiles - Personal property (furniture, jewelry) - Other (business ownership, collections)
Time - longer time can ride out ups and downs
As the length of the investment horizon increases, you can afford to invest in riskier assets. - If investment horizon is longer, will probably end up with a lot more if you invest in some risky assets.
Investments
Assets that have the potential to generate returns - Returns can be from income or appreciation EX: stock pay dividends and bonds pay interest, so these are considered investments *Remember, investment may not have income or may not have gain or loss depending on situation
Dividend Reinvestment Program (DRIPs)
Automatically reinvest the dividends in same firm's stock without brokerage fees. - Use to reinvest rather than spend your dividends. - Still pay income taxes. - Stuck reinvesting in old company instead of new.
Categories of stock
Blue chip Growth Income Cyclical Defensive Large-, mid-, small-cap
Pros and cons of investing in bonds
Bonds carry less risk than stocks. - They also reduce risk through diversification because they often behave differently than stocks. - True for category of bond but not always individual bonds Bonds provide steady income. Bonds can be a safe investment if held to maturity. - If the company lasts that long... Benefits: If interest rates drop, bond prices will rise. - If interest rates drop, that inverse relationship between interest rates and bond prices will work in your favor. - In that case, you'll want a long-term, noncallable bond. Bonds reduce risk through diversification. - Any time you add a new investment to your portfolio that doesn't move in tandem with the other investments in your portfolio, you reduce your portfolio risk. Bonds produce steady current income. Bonds can be a safe investment if held to maturity. - If you hold the bond to maturity and it doesn't default, it'll return exactly what it promises. Dangers: If interest rates rise, bond prices will fall. - The longer the maturity, the more the bond will fluctuate. If the issuer experiences financial problems, the bondholder may pay. - If an issuer can't make interest or principal payments, the bond will plummet in value. - Minor financial problems can also cause the bond to drop in value. - Of course, any time the bond rating drops, bond values drop like a stone. If interest rates drop, the bond may be called. - Most corporate bonds are callable. - In theory, when interest rates drop, the value of a bond should rise. - However, the issuer may decide to refinance the bond offering with bonds that have a lower interest rate. - The bonds may be called away, leaving investors to reinvest the proceeds form the called bonds at lower interest rates. If you need to sell your bonds early, you may have a problem selling them at a reasonable price, particularly if they're bonds issued by a smaller corporation. - There isn't a strong secondary market for the bonds of smaller corporations. - In short, bonds aren't a very liquid investment. Finding a good investment outlet for the interests you receive may be difficult. - If you're using bonds to accumulate wealth, it may be difficult to find a good investment outlet for the interest you receive. - Without reinvesting the interest payments, there'll be no accumulation of wealth from investing in bonds unless you're investing in zero or very low coupon bonds. If I buy a bond below par, I will have a capital gain. If I buy a bond above par (at a premium), I will have a capital loss.
Short Selling
Borrow, sell and rebuy in hopes price drops - Take advantage of a price decrease (the more the price drops, the more money you make) 1) Borrow stock from the broker (Margin requirement - collateral) 2) Sell high 3) Later buy low (key) - If price increases, you buy back for more than the sold price and lose money. 4) Return stock to broker Profit = Sales Price - (Repurchase Price + Dividends)
Long Selling
Buy stock, hold while price increases, sell for a profit - Profit = (Sale Price + Dividends) - Purchase Price
Speculation
Buying an asset whose value depends solely on supply and demand, as opposed to being based on the return that it generates - Speculators hope to "buy low and sell high" EX: Gold coins and baseball cards are worth more in the future only if someone is willing to pay more for them
Net asset value (NAV) & calculating returns (high level)
Calculated at the end of the market day - Unit = price per share - Return can be in the form of dividends, capital gains, or an increase in net asset value (NAV) - Automatic reinvestments result in increases in the NAV and number of shares - Return = ratio between how much money you actually earned on the investment compared to how much you initially spent RATE OF RETURN formula = Ending NAV - Beginning NAV / Beginning NAV
Liquid monetary assets - why important
Cash and investments that can easily be converted into cash - Low risk, low return - more cash = greater temptation to spend - Ex: checking accounts, CDs Are a necessity of personal financial management! - Risk: Might have to compromise your long-term investments to cover unexpected expenses - Prevention method: Have liquid funds and manage them effectively
Bankruptcy - Chapter 7 vs. 13
Ch 7 Straight Bankruptcy (60%) - Most debts wiped out—not child support, alimony, student loans, and taxes - Trustee collects, sells all nonexempt property - Must complete credit counseling course - Can eliminate debts and begin again - "Means test" Who Can File? - Your income < median state income, - Monthly disposable income < $100, or - Disposable income < 25% of debt over 5 years Repayment Requirements? - Assets liquidated to pay off creditors Long-Term Effect on Your Credit File? - Bankruptcy information remains in your credit file for 10 years Ch 13 The Wage Earner Plan (40%) - For the individual—relief from harassment of bill collectors - For creditors—controlled repayment with court supervision Who Can File? - Your income > median state income, - Monthly disposable income > $100, or - Disposable income > 25% of debt over 5 years Repayment Requirements? - Disposable income after living expenses used to pay off debt over a 3- to 5-year period (repayment schedule) Long-Term Effect on Your Credit File? - Bankruptcy information remains in your credit file for 7 years from the end of repayment *New laws in 2005 reduced the number of filers eligible for Ch 7
Types of accounts
Checking: - Federally protected account in which you deposit your liquid funds so you can withdraw them quickly and easy by means of written a check or debit card Advantages: Safe, liquid, low minimum balance, convenient Disadvantages: Monthly fee, opportunity cost, minimum balance required, lower interest than alternatives Savings: - Allows you to keep your money in a safe, federally insured financial institution while it earns a guaranteed fixed return or interest Advantages: Liquid, Safe (federal insured), higher interest than checking Disadvantages: Minimum holding time, charges/fees, low interest rate CDs (Certificates of Deposit): - Pays a fixed rate of interest while funds are on deposit for a period of time (30 days to years). - Put in a lump sum of money, wait a specified period of time, withdraw your money plus interest Advantages: Safe, fixed interest rate, convenient, money is in a separate bucket (away from checking/savings) Disadvantages: Early withdrawal penalty, fixed interest rate, minimum deposit required Non-bank institutions = U.S. Treasury Bills (T-bills): - Short-term debt issued by the federal government with maturities from 3-12 months. Advantages: Risk free, tax benefits (state and local exempt, federal varies) Disadvantages: Low rate of return U.S. Savings Bonds: - Series EE and I bonds are safe, low risk savings products issued by the Treasury with low denominations. Advantages: Safe, affordable, no taxes, convenient (redeem at any bank) Disadvantages: Low liquidity, long maturity, low interest rate, semi-annual compounding
Credit cards and terminology
Credit = Receiving cash, goods, or services with an obligation to pay later Consumer Credit = Credit purchases for personal needs other than for him mortgages (ex: credit card debt) Open Credit/Revolving Credit = A line of credit that you can use then pay back at whatever pace you like so long as you pay a minimum balance each month, paying interest on the unpaid balance - Have to stay under the credit limit - As long as you pay the minimum every month, you will have the line of credit - Unpaid balances plus interest carry over to next billing cycle - Higher balances on credit lines, higher costs Advantages: easy to make purchases, can be used as identification, can buy something now and pay later Disadvantages: too easy to spend money, easy to lose track of how much you spend, easily lose control of spending, high interest rate
Credit reports - high overview of what is in it and where it comes from
Credit Bureau = Company that gathers info on consumers' financial history, including how quickly they have paid bills and whether they have been delinquent on bills in the past - Put together a report and assign you a credit score based on their evaluation of your creditworthiness EX: Transunion and Experian Credit Report contains only information regarding your financial situation and dealings = Contains: - Identifying Information (name, address, social, DOB) - Trade Lines or Credit Accounts - Inquiries (requests for a copy of your report) - Public Record and Collection items (bankruptcies, foreclosures, suits)
Real Return formula
Current or nominal rate of return minus the inflation rate: Total Return - Rate of Inflation - Can be negative
Volatility as measure of risk (beta)
Degree of variation in investment returns - Standard Deviation is variation around the mean - risk = volatility - Influenced by asset class or type and holding period - Shorter time period = more risk
Liabilities
Debts that must be repaid in the future Current debt: - Due within a year or less - Ex: credit cards, utility bills Long term debt - Due in more than one year - Ex: Home mortgage, auto loans, student loans Types: - Moral Debt = you owe a friend $5 - Legal Debt = you owe the IRS $1000 - Contractual Debt = you owe the credit card company $4000
How do you make money from owning stock? (2 reasons)
Dividends: The company's distribution of profits to stockholders. - paid at the board's discretion Capital appreciation: The increase in the selling price of a share of stock - takes place when the company does well NEITHER ARE GUARANTEED
Management fees & expenses (what are these?)
Expense ratio - the ratio of a mutual fund's expenses to its total assets (%) - Invest in a fund with a low expense ratio Turnover rate - measures the level of the fund's trading activity (%) - Higher turnover rate, higher the fund's expenses Fee Structure: Sales Loads - Front-end load (A shares) Operating expenses Fees and performance
Consumer loan
Formal contract detailing how much you're borrowing, when, and how you're going to pay it back - Used for bigger purchases (i.e. homes and vehicles)
Junk Bonds
High-yield bonds, risky, low-rated BB or below - High-risk, high-interest
Asset allocation
How your money should be divided among stocks, bonds, and other investments - Key concept: Properly adding asset classes to portfolio reduces risk. - Investments diversified in different classes of investments. - Common stocks are more appropriate for the long-term horizon. - The most important investing task that is not a one-time decision. - Closely tied to personal situation (age, finances, goals, and family needs are key) - No one asset allocation rule applies to all
ETFs (Exchange Traded Funds)
Hybrid between a mutual fund and an individually traded stock or bond - Trade like an individual security - Can be bought and sold through the trading day - The investments inside the ETF do not change very often EX: an S&P 500 ETF Dollar Value: - Charges lower annual expenses but still pay trading commissions - More tax-efficient than most mutual funds - Allow investors to stake out an investment position in a sector, industry, or country - Investors can buy or sell throughout the market's trading hours Advantages: - Can be bought and sold throughout the trading day - Can be sold short or bought on margin - Allow you to take an instant position in a sector or country that you may not otherwise have access to - Very low annual expenses - More tax-efficient than most mutual funds Disadvantages: - Pay commission - Don't necessarily trade at their net asset value - Bid-ask spread - Can be more expensive than typical mutual funds due to brokerage costs
6) Explain how changes in interest rates affect bond prices. What does this mean for investors?
INVERSE RELATIONSHIP = IR up then bond price down - If you expect interest rates to go up (bond prices to fall), purchase very short-term bonds - If you expect interest rates to go down (bond prices to rise), purchase bonds with long maturities and are not callable. - Interest rates act as a "base" return. When interest rates go up, investors demand a higher return on other investments.
General Return Differences by broad asset class over time (i.e. what types of asset classes earn the most over time and which ones earn the least)
Investment in bonds will give less uncertainty over time but will give smaller ultimate value than investing in riskier assets like stocks.
Effects of inflation and present value of future lump sum
Inflation eats away at the spending power of the currency over time, making it worth less in the future. Strip away inflation to see what future cash flows are worth today - Inverse of compounding Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. - Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.
Compound interest
Interest paid on interest. This occurs when interest paid on an investment is reinvested and added to the principal, thus allowing you to earn interest on the interest, as well as the principal - Credited daily, monthly, quarterly or semiannually - Shorter compounding period = faster money growth (Sooner paid = sooner earned = more compounding = more money) - The cornerstone of time value of money is compound interest.
Simple Interest
Interest paid on the principal alone - Principal = face value of the deposit or debt instrument
Features of stocks
Investors willing to accept the risk of fluctuating share prices in return for potential capital growth and increasing dividend income - Ownership: with interest in a corporation, you are entitled to a proportionate share of the control, profits, and assets of the corporation. - Receives share of corporate profits through dividends - Generates appreciation - Exercise control through voting rights (Proxy) - If corporation is sold or liquidated, share net proceeds Advantages: - Long-term returns almost twice fixed income investments - Highly Marketable - Wide range of companies to invest in Disadvantages: - Volatility (tax and interest rate changes and general economic conditions) - Dividends not guaranteed Interest rates, risk, and expected future growth determine the value of common stock
Munis (municipal bonds)
Issued by states, counties, cities, public agencies e.g. school districts - General obligation bond - Revenue Bonds - paid via revenues of specific entity (ex - Miller Park, Fluno Center) Generally, interest from these bonds is exempt from federal income tax
Difference between "lending investments" and "ownership investments"
Lending: - "lend" your money to an institution and receive income from interest or dividends EX: Savings accounts and bonds, which are debt instruments issued by corporations and by the government Ownership: - Investing in something that generates a return: rent - Participate in success, and/or failure of the firm EX: Preferred stocks and common stocks, which represent an ownership position in a corporation, along with income-producing real estate
Amortization What are monthly payments made up of (principal and interest)
Loan amortization = the repayment of a loan using equal monthly payments that cover a portion of the principal and the interest on the declining balance. The amount of the monthly payment going toward interest starts off large and steadily declines, while the amount going toward the principal starts off small and steadily increases. (Installment; paying off a loan) - A fixed repayment schedule in regular installments over time to pay a mortgage or a car loan - EX: cars, appliances The gradual elimination of a liability (or loan) in regular payments over a specified term. Full amortization is when payments are such that the loan balance is zero after the final payment. (FV = 0)
Time Value of Money (TVM)
Money receive today is worth more than money received in the future What you can solve for: - Monthly payment on a car loan - How much you need to save to buy a Tesla in 2025 - The interest rate you need to get on an investment to retire in 40 years - How long it will take to pay off a credit card balance 5 components: - Present Value (PV) = what is it worth in today's dollars - Future Value (FV) = what is it worth in future dollars - Interest rate (i) - Period (N) = number of months or years - Payment/savings (PMT) = each month/year
Type of orders (stocks)
Market Order = Buy or sell immediately at the best price available (most of individual trades) Stop Order = Sell if price drops below a specified level or buy if the price climbs above a specified level Limit Order = Trade only at a certain price or better - "Buy if price goes as high as $XXX"
Beta
Measure of how responsive a stock or portfolio is to changes in the market portfolio - Beta benchmark for market = 1 - Beta > 1 = stock moves up and down more than market - Beta < 1 = stock moves up and down less
Stock indexes
Measure of performance of a group of stocks that represent the market or a sector of the market - Show health of stock market EX: Dow Jones; NASDAQ, S&P 500, DOW
Solving for PV, FV, N, I, PMT
Monthly Payments - i and N are affected - Divide i by 12 months and Multiply N by 12 Payments are negative • Using calculator: remember to watch for time periods (monthly, quarterly, annually) and make sure N and I/Y are correct; make sure the use negatives correctly so your calculation works correctly
Credit scores - based on report; what helps/hurts the score
Numerical scoring of credit applicants based on credit history - Influences everything from the rate you pay your credit cards, to the size of your credit line, to your insurance rates, to your mortgage rate - Strong credit score = lower interest rates - National avg. score = 711 (300-850 scale) - Good score = 760 or higher (to get best mortgage rate) 5 factors that determine your score: - Your payment history (35%) - The amount you owe and your available credit (30%) - Length of credit history (15%) - Types of credit used (10%) - New Credit (10%) Help your score = don't skip payments, have a low debt-to-credit ratio, longer you have an account open then the higher your score will be, wider the variety of credit you have the better (can handle multiple credit lines), and don't have a lot of applications for credit EX: FICO
Features of bonds
Par Value = The stated amount on the face of a bond, which the firm is to repay at the maturity date - Typically $1000 per bond Coupon Rate = The interest to be paid annually on a bond as a percentage of par value, which is specified in the contractual agreement Maturity date = The date at which the borrower must repay the loan or borrowed funds - when the bond's issuer returns the par value to the investor & terminates the bond
Primary markets - IPOs
Place where new securities are traded/sold - Seasoned new issues: new issues of already public stock is created - Investment Banker: sells securities - Underwriter: administer the IPO and distribution of securities - Prospectus: document delivered to potential investors containing information about a security - Tombstone advertisement: provides basic details about the public offering of a security IPOs: The first time a company's stock is traded publicly - Show how much a company is worth in the public's eye - Mostly large investors
Risk/Reward Trade off and Volatility/Standard Deviation (beta) - what does beta tell an investor?
Principle 8 = can eliminate/reduce risk associated with common stock by diversifying - Leaves on systematic risk and is measured using Beta Risk associated with stocks - Short-term investments in stocks are very risky - Holding stocks longer reduces variability of average annual return
Bonds
Promise to pay: - Specified interest/dividend - Face Value at Maturity In return for: - Lending money to initial bond issuer - A bond issuer (company or gov't entity) is looking for a loan so it decides to issue bonds. - Investors buy said loans. - When an investor lends money to the entity, they get a predictable interest rate and money back at the end of the term. - Bonds are considered less risky because they have more predictability due to their set interest rate and return of investment. Bonds trade after their initial sale at prices above or below par
Dollar cost averaging
Purchasing a fixed dollar amount of stock at specified intervals. - Same dollar amount each period will average out the fluctuations. - Buy more shares at a lower price, fewer shares at higher prices. - Keeps you from trying to time the market. - Retirement plans are great for this
Treasury & Agency bonds
Risk-free Not callable Lower interest rate - Most interest payments are exempt from state and local taxes. Bills, notes, and bonds differ only by maturity and denomination. - Treasury-issued debt has maturities from 3 months to 30 years. Treasury Inflation Protected Securities (TIPS): par value changes with the consumer price index to guarantee investor a real rate of return Government bonds for individual consumers (U.S. Series EE Bonds and I Bonds) Advantages: - Virtually free of the risk of default. - Income assured. - Readily accepted as collateral for loans. - Easily and quickly convertible to cash - Highest degree of security and comfort for risk conscious investors. - A large variety of government issues is available. - Interest earned not subject to state and local taxation. - TIPS provide long-term inflation protection Disadvantages: - Rate of return on U.S. government securities is generally lower than other fixed-income securities. - Long-term government issues are subject to a high degree of interest rate risk. (Prices can fluctuate substantially with changes in interest rates.) - Purchasing power of the fixed amount of dollars paid by these issues will be eroded over time by the effects of inflation. (Exception is TIPs)
Secured vs. Unsecured loans
Secured loan - guaranteed by an asset which typically lowers the rate of the loan - Requires collateral! EX: car, boat, house, land - If you can't meet the loan payments, that asset can be seized and sold to cover the amount due Unsecured loan - not guaranteed by an asset or collateral - Harder to get (need excellent credit history) - Usually small $ amount
Corporate Bonds
Secured vs unsecured corporate debt - Secured = Mortgage bond - Unsecured = Debenture Legal evidence of a long-term loan Typically the loan must be repaid as of a specified date (Maturity date) Interest at a stated rate paid by the corporation to the bondholder - Generally paid every six months - The interest rate is usually fixed when the bonds are issued Subject to larger default risk than government securities Options include callable and convertible
Expenditures
Spending money - hard to calculate because many are cash transactions and don't leave a paper trail Fixed = Expenditure over which you have no control. You are obligated to make that expenditure, and it is generally at a constant level each month Variable = Expenditure over which you have control. You aren't obligated to make that expenditure and it may very from month to month
Steps of financial planning
Step 1: Evaluate your financial health - Examine your current financial situation. - How much money do you make? - How much are you spending and on what? Step 2: Define your financial goals - Attach a financial cost to each one (You want to go to Thailand after graduation. How much will it cost?) - When will you need the money to achieve the goal? Step 3: Develop a plan of action - Flexibility, Liquidity, Protection, Minimize taxes Step 4: Implement your plan Step 5: Review your progress, reevaluate, and revise your plan
Financial ratios (Financial thermometers)
Targets or standards in managing financial resources: Current Ratio = Aimed at determining if you have adequate liquidity to meet emergencies - Monetary assets / Current liabilities = current ratio Month's Living Expenses Covered Ratio = Aimed a determining if you have adequate liquidity to meet emergencies - Monetary assets / Annual living expenditures divided by 12 - Should aim for 3 to 6 months of liquid assets Debt Ratio = Aimed at determining if you have the ability to met your debt obligations - Total debt/liabilities / Total assets - Should decrease as you get older - Greater than 1.0 is a red flag Savings Ratio = Aimed at determining how much you are saving - Income available for savings and investments / Income available for living expenses - Higher is better
Trade off of risk and return
The more risk you assume, the greater the potential reward - but also the greater possibility of losing your money Types: Interest Rate risk Inflation risk Business risk Financial risk Liquidity risk Market risk Political and regulatory risk Exchange Rate risk Call risk
Rule of 72*
The number of years it takes for a certain amount to double in value is equal to 72 divided by its annual rate of interest. - time to double investment = 72 / i% EX: If an investment grows at an annual rate of 9% per year, how long will it take to double? 72 / 9 = 8 years to double
Diversification
The reduction of risk by investing in different assets - investing in stocks from different industries (technology, retail, medicine, etc.) - Allows extreme good and bad returns to cancel each other out. - Reduce risk without affecting expected return
Short Answer Questions
These will ask you to list or summarize a concept. For example: 1) Name 3 advantages & 1 disadvantage of being a Badger. ANSWER: Advantages: (1) awesome campus, (2) great education, (3) Big 10 Disadvantage: long winters 2) What is a reason that Linda likes her American Express credit card? What could get her in trouble if she's not careful? ANSWER: She earns miles on Delta. If she spends too much on her trips, she may not be able to pay the balance off quickly.
How to set up financial goals
Time horizons: Short term (less than a year) - Immediate impact on cash flow - Saving is key EX: Bills, day to day Intermediate term (2-10 years) - More time, less impact on cash flow - Limited investment opportunity EX: College, wedding, kids Long term (10+ years) - Investing is what will achieve these goals EX: Retirement
Comparing interest rates
To compare returns that are either (1) listed at something other than 1 year or (2) compounded more often than annually, you must use Annual Percentage Yield (APY) - APY is the annualized rate of return that comes from compounding more frequently than once per year Formula: APY = (1 + i/n)^n - 1
Consumer Disclosure: APR
Truth in Lending Act = Must disclose APR Loan Disclosure agreement = provides the APR and interest charges associated with a loan
Schumer Box
Truth in Lending Act requires institutions to list the costs of credit cards in order for customers to avoid unexpected finance charges. It is helpful for consumers in comparing credit card offers and it tells all the little details. The credit card issuer must tell you: •the APR or APRs •finance charges, including the minimum finance charge •the minimum payment required •the method used for computing your outstanding balance •the actual company offering you credit (sometimes not the company marketing the card) •the credit limit •the grace period •the annual fee, if any •the fees for credit insurance, if any
TEY (taxable equivalent yield)
Use TEY to compare a corporate bond to a muni to see which is the best deal TEY = tax-free yield on muni bond / (1 - investor's marginal tax bracket) EX: Consider a muni bond with a coupon of 4% and a corporate bond with a coupon at 5%. You are in the 33% tax bracket. Which is the better deal? TEY = coupon rt/(1-tax bracket) TEY = 0.04/(1-0.33) = 0.04/ 0.67 = 5.97% The muni bond is the better deal
Formula for Current Return of a bond
What is the current yield of a bond w/a price of $1100 and 4% coupon? Current yield = $40/$1100 = 3.64% A bond at $900 and 4% coupon Current yield = $40/$900 = 4.44% Current yield = annual interest payments / bond's market price
Why own stock?
When you buy common stock, you purchase a part of the company - Receive returns from dividends and capital appreciation - Over time, common stocks outperform all other investments - Reduce risk through diversification - Are liquid - Growth is determined by more than interest rates
Secondary markets - exchanges (NYSE, NASDAQ, eBay)
Where stocks (or other items) are re-traded after their initial public offering - Previously issues securities! - Types: Auction (NYSE), Dealer (Stocks), Direct Search(eBay) and Brokered(IPOs)
Rate of Return formula
[ ($ ending value - $ purchase price) + $ income ] / $purchase price
Liquidity
the relative ease and speed with which an asset can be converted into cash