fin 307 exam 2

Interest rate risk

- a rise in interest rates before bond is sold could mean a capital loss.

Amortized loans

- the borrower pays off part of the principal along with the interest for the life of the loan.

Consol

-are like coupon bonds whose payments last forever -The borrower pays only interest, never repaying the principal -The U.S. government sold ____ once in 1900, but the Treasury has bought them all back. -The price of a ____ is the present value of all future interest payments. Example: U.K. government has some outstanding

Factors That Shift Bond Supply

1. Changes in Government Borrowing 2. Change in General Business Conditions 3. Changes in Expected Inflation Shift supply to the right

Derivatives are different from outright purchases because:

1.Derivatives provide an easy way for investors to profit from price declines 2.In a derivatives transaction, one person's loss is always another person's gain.

call option; strike price

A ______ is the right to buy, "call away", a given quantity of an underlying asset at a predetermined price, called the ______ (or exercise price), on or before a specific date.

credit-default swap (CDS

A _______ is a credit derivative that allows lenders to insure themselves against the risk that a borrower will default. The buyer of a CDS makes payments, like insurance premiums, to the seller, and the seller agrees to pay the buyer if an underlying loan or security defaults. The CDS buyer pays a fee to transfer the risk of default, the credit risk, to the CDS seller. A CDS agreement often lasts several years and requires that collateral be posted to protect against the inability to pay of either the seller or the buyer of the insurance.

junk bonds

A bond with a high risk of default. Also called a high-yield bond.

Current yield

A bond's yearly coupon payment divided by its current market price. The current yield measures that part of the return from buying the bond that arises solely from the coupon payments. If the price is below par, the current yield will be below the yield to maturity.

mutual fund

A fund that pools the resources of a large number of small investors and invests them in portfolios of bonds, stocks, and real estate; managed by professional managers.

benchmark bond

A low-risk bond, usually a U.S. Treasury bond, to which the yield on a risky bond is compared to assess its risk.

rating

A measure of the default risk associated with a company's debt; normally a series of letters going from AAA for bonds with the lowest risk of default to D for bonds that have defaulted.

bubble

A persistent and expanding gap between actual asset prices and those warranted by the fundamentals; usually created by mass enthusiasm.

yield curve

A plot showing the yields to maturity of different bonds of the same riskiness against the time to maturity.

Zero-coupon or discount bond

A promise to pay the face value of the bond on a specific future date, with no coupon payments. Example: Treasury bill

Standard & Poor's 500 Index

A stock-market index that is based on the value of 500 of the largest firms in the U.S. economy.

U.S. Treasury bills (T-bills)

A zero-coupon bond in which the U.S. government agrees to pay the bondholder a fixed dollar amount on a specific future date; has a maturity of less than one year.

Central Counterparty (CCP)

An entity that interposes itself between the two sides of a transaction, becoming the buyer to every seller and the seller to every buyer.

price-weighted average

An index based on the average price of a collection of individual stocks. Price-weighted averages give greater weight to shares with higher prices.

value-weighted index

An index that is based on the value of the firms, like the S&P 500. Value-weighted indexes give greater weight to larger firms

investment-grade bond

Bond with low default risk; Moody's rating of Baa or higher; and Standard & Poor's rating of BBB or higher.

municipal bonds

Bonds issued by state and local governments to finance public projects; the coupon payments are exempt from federal and state income taxes. Also called tax-exempt bonds

investment-grade bonds.

Firms or governments with an exceptionally strong financial position carry the highest ratings and are able to issue the highest-rated bonds, Triple A. The top four categories are considered

pt2: Yield to Maturity FV = 1000

If Bond Price = $1000, Yield to maturity = the coupon rate If Bond Price > $1000, Yield to maturity < the coupon rate If Bond Price < $1000, Yield to maturity > the coupon rate Bond Price up ==> Yield to maturity down

notional principal

Interest-rate swaps are agreements between two counter parties to exchange periodic interest-rate payments over some future period, based on an agreed-upon amount of principal, called the _____

Pricing Options: Intrinsic Value and the Time Value of the Option: An option has two parts: Time value of the option

Intrinsic value - the value of the option if it is exercised immediately, and ________- the fee paid for the option's potential benefits.

The best known bond rating services are

Moody's Standard & Poor's

Coupon bond

Periodic interest payments + principal repayment at maturity Example: U.S. Treasury Bonds and most corporate bonds

Increasing expected inflation

Reduces the real cost of borrowing shifting bond supply to the right. But, lowers real return on lending, shifting bond demand to the left.

commercial paper

Short-term, privately issued zero-coupon debt that is low risk and very liquid and usually has a maturity of less than 270 days.

common stock

Stocks, also known as _______ or equity, are shares in a firm's ownership.

bond supply curve

The ______ curve is the relationship between the price and the quantity of bonds people are willing to sell, all else equal.

holding period

The _______ return is the return to holding a bond and selling it before maturity

purpose of derivatives

The ________ is to transfer risk from one person or firm to another.

Dow Jones Industrial Average (DJIA)

The best-known index of stock market performance, it measures the average price of a single share in 30 very large and well-known American companies.

marking to market.

The clearing corporation posts daily gains and losses on the contract to the margin account of the parties involved. Doing this each day ensures that sellers always have the resources to make delivery and buyers can always pay.

margin

The clearing corporation requires both parties to a futures contract to place a deposit with the corporation. This guarantees when the contract comes due, the parties will be able to meet their obligations.

swap spread

The difference between the benchmark interest rate and the swap rate, it is a measure of risk

swap spread

The difference between the benchmark rate and the swap rate is called the -________ and is a measure of risk.

interest rate spread

The difference between the interest rate a bank receives on its assets and the interest rate it pays to obtain liabilities. (12) 2. Can also be used as a synonym for risk spread.

spread over Treasuries

The difference between the yield on a bond and that on a U.S. Treasury with the same time to maturity; a measure of the riskiness of the bond.

residual claimant

The final person to be paid. Stockholders are residual claimants; if the company runs into financial trouble, only after all other creditors have been paid will they receive what is left, if anything.

term spread

The gap between yields to maturity on a long- and a short-term bond (usually free of default risk); see also yield curve.

bond

The higher the price of a, _____ the larger the quantity supplied. The bond supply curve slopes upward.

The higher the default risk

The higher the yield

Coupon Bonds

The issuer of a coupon bond promises to make a series of periodic interest payments (coupon payments), plus a principal payment at maturity.

Wilshire 5000

The most broadly based value-weighted stock index in use. It covers the roughly 6,500 publicly traded stocks in the United States.

theory of efficient markets

The notion that the prices of all financial instruments, including stocks, reflect all available information

pt 2:holding period

The one-year holding period return is the sum of the yearly coupon payment divided by the price paid for the bond and the change in the price divided by the price paid.

fixed-rate payer

The party to an interest-rate swap that is making fixed payments.

Dividends

The payments made to a company's stockholders when the company makes a profit.

arbitrage

The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences is called _____ the people who engage in it are called arbitrageurs

fundamental value

The present value of the expected future returns to owning an asset, which equals the asset's price in an efficient market.

expectations hypothesis of the term structure

The proposition that long-term interest rates are the average of expected future short-term interest rates.

liquidity premium theory of the term structure

The proposition that long-term interest rates equal the average of expected short-term interest rates plus a risk premium that rises with the time to maturity.

limited liability

The provision that even if a company fails completely, the maximum amount that shareholders can lose is their initial investment.

prime grade commercial paper

The rating agencies rate the creditworthiness of commercial paper issuers in the same way they do bond issuers. Almost all carry Moody's P-1 or P-2 rating ________paper. Speculative-grade commercial paper does exist, but not because it was issued as such.

risk structure of interest rates

The relationship among the yields of bonds with the same time to maturity but different levels of risk

Options are agreements between two parties

The seller is an option writer. A buyer is an option holder

dividend-discount model

The theory that the fundamental value of a stock equals the present value of expected future dividend payments.

Market Capitalization

The total market value of a company; the price of a share of stock times the total number of shares outstanding.

Nasdaq Composite Index

The value-weighted index of more than 5,000 companies traded on the over-the-counter (OTC) market through the National Association of Securities Dealers Automatic Quotations service; the index is composed mainly of smaller, newer firms and in recent years has been dominated by technology and Internet companies.

Yield to Maturity

The yield bondholders receive if they hold the bond to its maturity when the final principal payment is made

risk spread

The yield over and above that on a low-risk bond such as a U.S. Treasury with the same time to maturity, it is a measure of the compensation investors require for the risk they are bearing. Also called a default risk premium.

writer

The______ of the option is obliged to buy the shares should the holder choose to exercise the option.

what does Moody's and Standard & Poor do

They monitor the status of individual bond issuers and assess the likelihood a lender will be repaid by the bond issuer. A high rating suggests that a bond issuer will have little problem meeting a bond's payment obligations.

capital gain

This rise in value is referred to as a _____ and is part of the return on your investment.

Bond Yield is Sum of Two Parts

US Treasury Yield + Default Risk Premium

Factors That Shift Bond Demand

Wealth Expected Inflation Expected Returns and Expected Interest Rates Risk Relative to Alternatives Liquidity Relative to Alternatives Shift demand to the right

capital loss

When the price of a bond is higher than face value, the bondholder incurs a _____

manage and reduce risk.

While derivatives can be used to speculate, or gamble on future price movements, they allow investors to _____

Supply and Demand

______ and ____determine bond prices (and bond yields).

bond demand curve

_______ is the relationship between the price and the quantity of bonds that investors demand, all else equal The bond demand curve slopes downward.

Futures contracts allow

_______ the transfer of risk between buyer and seller through hedging or speculation.

Interest-rate swaps

______are agreements between two counterparties to exchange periodic interest-rate payments over some future period, based on an agreed-upon amount of principal, called the notional principal.

taxable bond

a bond whose coupon payments are not exempt from income tax - Bondholders must pay income tax on the interest income they receive from owning privately issued bonds

inverted yield curve

a yield curve that is downward sloping

Fallen angels

are bonds that were once investment-grade, but their issuers fell on hard times. Bonds issued by issuers about which there is little known.

who uses interest rate swaps

banks, Gov Debt managers

prime-grade commercial paper

commercial paper with a low risk of default

put option

gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date

stock-market indexes

index numbers that provide a sense of whether the value of the stock market is going up or down

Inflation risk

investor cannot be aware of the real of the payments made. The risk that the real value of the payments from owning a bond will be different from what was expected; that the real interest rate on a bond will differ from what was expected.

derivative

is a financial instrument whose value depends on, is derived from, the value of some other financial instrument, call the underlying asset. Examples of assets include stocks, bonds, wheat, snowfall, and stock market indexes like S&P 500

future or futures contract

is a forward contract that has been standardized and sold through an organized exchange. The contract specifies that the seller (short position) will deliver some quantity of a commodity or financial instrument to the buyer (long position) on a specific date, called the settlement or delivery date, for a predetermined price

forward, or forward contract

is an agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date. Because they are customized, forward contracts are very difficult to resell.

default risk premium

premium is the promised yield to maturity minus the risk-free rate:

fixed payment loan

sequence of fixed payments; They promise a fixed number of equal payments at regular intervals ex: mortgage or car loan

Default risk

the chance the bond's issuer may not make payment. The probability that a borrower will not repay a loan; see also credit risk

stock market

the market where the prices of common stock are determined

floating-rate payer

the party to a swap that makes floating payments in exchange for fixed

investment horizon

the period of time an investor plans to hold a particular investment

interest-rate risk

the risk that arises for bond owners from fluctuating interest rates

Ratings upgrade

upgrade an issuer's bond rating.