Finance Exam 2
The efficient-market hypothesis
(EMH) is a theory describing the behavior of an assumed "perfect" market in which securities are in equilibrium, security prices fully reflect all available information and react swiftly to new information, and because stocks are fully and fairly priced, investors need not waste time looking for mispriced securities.
Collateral
specific assets that are designated as security for a bond. That is, if the bond issuer does not have enough cash to make the payments on the bond, then the collateral will be given to the bondholder instead
Liquidity preference theory
suggests that long-term rates are generally higher than short-term rates (hence, the yield curve is upward sloping) because investors perceive short-term investments to be more liquid and less risky than long-term investments. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities.
Market segmentation theory
suggests that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment.
convertible
the bondholder, rather than the bond issuer, can exchange the bond for some other security, usually stock
term spread
the difference between two bonds with the same level of risk but different maturities
In the formula r=𝐷1/𝑃0+𝑔, what does g represent?
the expected price appreciation yield from a common stock
Where E(Rp) represents:
the expected return for the portfolio, E(Rj) is the expected return for stock j, and wj is the weight for stock j. The weights are just the percentage of the total portfolio value of each stock at the beginning of the period: weight for stock j = wj= 𝑡𝑜𝑡𝑎𝑙𝑣𝑎𝑙𝑢𝑒𝑜f𝑠𝑡𝑜𝑐𝑘𝑗/𝑡𝑜𝑡𝑎𝑙𝑣𝑎𝑙𝑢𝑒𝑜f𝑝𝑜𝑟𝑡f𝑜𝑙𝑖𝑜
yield-to-maturity
the interest rate if we take the price as the present value, the coupon payments as the payments, and the face value as the future value
callable
the issuer can repurchase the bond at some fixed price
maturity date
the principal amount to be paid at maturity
The real risk-free rate of interest is
the rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation
variance
the weighted average of squared deviations and is usually represented by the symbol σ2
What are the features of the US Treasury?
the yields on US treasuries are commonly used as a benchmark in order to evaluate the impact of risk on other bonds no risk of default US treasury bond will have a higher price and lower yield than the corporate bond if they have the same time to maturity They can have risk arising from other sources, such as politics, inflation, changing interest rates, taxes, and liquidity
Bonds issued by the US Treasury are referred to as ___________ and they are risk free
treasuries
True of False The value of a share of stock should be the present value of all future cash flows payable to shareholders, discounted at a rate that accounts for risk.
true
corporate bonds
usually make fixed coupon payments for fixed time periods, but can also have any of the exceptions described above
A firm's overall cost of capital can be computing by taking a weighted average of the costs of capital for the various securities that a firm has issued. This is called the _____________
weighted average cost of capital (WACC)
real interest rate
when an intrest rate is adjusted for inflation
Deviation
which measures how far away the actual return is from the expected return: actual return minus expected return = Ri - E(R)
Calculate the payoff of this scenario: You flip a coin, if it is Heads, you win $112; and if it is Tails, you lose $144
-16
What are the bond's features? -Bonds give no ownership rights to their owners -Bond's contract is called debenture -The principal amount is repaid at maturity -Bonds are not generally negotiable -securities that generally make fixed interest payments for a fixed number of time periods
-Bonds give no ownership rights to their owners -The principal amount is repaid at maturity -securities that generally make fixed interest payments for a fixed number of time periods
The discount rate that makes the present value of a bond's payments equal to its price is termed the:
yield to maturity.
Calculate real rate if you have nominal rate is 12% and inflation rate is 7%
4.67
The cost of capital for a firm with a 60/40 debt/equity split, 4.55% cost of debt, 15% cost of equity, and a 35% tax rate would be
7.78%
Calculate the expected return for two possible outcomes for the economy next year: recession and recovery Suppose for this example that we forecast a 97% chance of recession over the next year Let's suppose that we forecast that in a recession the firm's return will be 9.04% and that in recovery the firm's return will be 20.25%
9.37%
Which of the following bonds would be likely to exhibit a greater degree of interest-rate risk?
A zero-coupon bond with 20 years until maturity.
The benefits of portfolio diversification are highest when the individual securities have returns that
Are uncorrelated with the rest of the portfolio
seniority/ priority of payment
As an alternative to a bond having security to insure payment, bonds may also have a specific priority of payment
You are considering investing in a firm The dividend on the company's stock has not changed in the past ten years and most likely will not change in the foreseeable future. In this case, the most appropriate stock valuation model would be the _________ model.
zero growth
security
Characteristics that are directly related to "guarantees" of payment
Which component is more likely to be biased if book values are used in the calculation of WACC rather than market values?
Common stock.
the term intrest rate refers to:
Debt instruments such as bank loans or bonds; the compensation paid by the borrower of funds to the lender
Which of the following is correct for a bond priced at $1,100 that has ten years remaining until maturity, and a 10% coupon, with semiannual payments?
Each payment of interest equals $50.
the term required to return refers to
Equity instruments such as common stock; the cost of funds obtained by selling an ownership interest
True or false: The risk of default for bond means the bond buyer fails to make interest or principal payments
False
true or false Large and active stock markets are not very efficient because they do not react to relevent market news.
False
true or false Manager of actively managed funds are investment professional who typically beat the market.
False
____________________ are the total costs of issuing and selling securities. They include two components: Underwriting costs —compensation earned by investment bankers for selling the security. Administrative costs—issuer expenses such as legal, accounting, and printing.
Flotation costs
Complete the following sentence. The WACC _________________.
For a firm represents the risk and target capital structure of the firm's existing assets as a whole.
The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because individual stocks
Have no diversification of risk
If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be logical to invest in
High beta stocks
The term Liquidity preference theory refers to:
Long-term rates are generally higher than short-term because investors perceive short-term investments to be
zero-coupon bonds
Many bonds have no coupon payments at all
Market Segmentation Theory
Market for loans is segmented on the basis of maturity and that the supply and demand for loans within each segment
Inflation
Measures the growth rate in the prices of most goods and services over some period of time (monthly, quarterly)
_________________ are the funds actually received by the firm from the sale of a security
Net proceeds
________________________ represents a hybrid security, in that it has some characteristics like common stock and some characteristics that make it like debt.
Preferred stock
Which of the following statements best describes the real interest rate?
Real interest rates can be negative, zero, or positive.
The major benefit of diversification is to
Reduce the expected risk
________________________ is the attitude toward risk in which investors choose the investment with the higher return regardless of its risk.
Risk neutral
_________________________ is the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.
Risk seeking
true or false: Bond's principal amount is repaid at maturity
TRUE
cost of equity
The cost of capital for equity financing can be measured by the required stock return and is called the
coupon rate
The coupon rate is a percentage of the principal amount and determines how much each interest payment will be
What are the bond's features?
The principal amount is repaid at maturity Bonds give no ownership rights to their owners securities that generally make fixed interest payments for a fixed number of time periods
the real risk-free rate of interest is:
The rate that creates equilibrium between the supply of savings and the demand on investment funds in a perfect world
Which of the following statement is correct: The reduction in risk that is accomplished by combining stocks in a portfolio is called diversification The total risk can then be broken down into market risk and systematic risk The risk of a portfolio will be a weighted average of the risk of the individual stocks The demand for stocks by investors should depend on the stocks' individual level of risk
The reduction in risk that is accomplished by combining stocks in a portfolio is called diversification
standard deviation
The square root of the variance is called the standard deviation (SD) and is represented by the symbol σ:
Expectations Theory
Theory that the yield curve reflects investor expectations about future interest rates
default spread
This difference between two bonds that are similar except for their level of risk
Short-term Treasuries, with maturities of less than one year are called ___________ or T-_____
Treasury Bills or T Bills
Treasuries that had original maturities of more than 10 years are called ____________ or T-_______
Treasury Bonds or T Bonds
Ones with maturities of 1 to 10 years are called __________ or T-_____
Treasury Notes or T Notes
True of False: The yield is what we would consider to be the interest rate if we take the price as the present value, the coupon payments as the payments, and the face value as the future value.
True
True or False Bond's principal amount is repaid at maturity
True
True or False: In straight-line voting, each candidate for the board of directors is elected by a majority vote. Therefore, any voting block which controls 51% of the votes will be able to elect all board members. Straight-line voting tends to favor large blockholders at the expense of small shareholders.
True
True or false: For a given level of dividends, a higher stock price implies a lower expected return and a lower stock price implies a higher expected return.
True
Macro events only are reflected in the performance of the market portfolio because
Unique risks have been diversified away
The variance of an investment's returns is a measure of the:
Volatility of the rates of return
sinking fund
a bank account that holds the cash to be used to make a bond's payments.
Premium Bond
a bond that is selling above its par value
Par-value bond
a bond that sells for its par value
portfolio
a collection, or group, of assets.
Each stock has a value called ____________ that measures how much risk the stock contributes to portfolios in general.
beta (β)
cumulative voting
board seats are awarded in proportion to the votes received. Therefore, if a small block of voters represents 10% of shareholders, they will be able to elect 10% of the board members. The cumulative voting arrangement tends to favor minority shareholders.
Discount Bond
bond that is isusued for less than face/par value
The increase in the stock price over time is called a ____________
capital gain
Who can issue munis?
city government any branch of a state, county highway authorities, school districts, universities, airports, or public utilities
The cost of capital for debt financing is called the ___________ and can be measured by the yield to maturity on bonds.
cost of debt
The _____________________ represents the discount at which a firm must issue shares in order for investors to purchase them.
cost of equity
A stock's ______ is found by dividing the stock's annual dividend by its closing price.
current yield
Regret theory
deals with the emotional reaction people experience after realizing they have made an error in judgment. The anticipation of negative emotions leads to sub-optimal or irrational decisions. Fear of regret can lead investors to become extremely risk-averse (Links to an external site.) or motivate them to be risk-seekers (less risk-averse) and take excessive risks
The term interest rate is usually applied to
debt instruments such as bank loans or bonds; the compensation paid by the borrower of funds to the lender; from the borrower's point of view, the cost of borrowing funds
You have a portfolio that consists of equal amounts of IBM stock and Treasury bills. If you replace one-third of the IBM stock with more Treasury bills, the variance of the expected portfolio returns will
decrease
You plan to sell some of your General Motors common stock (which tends to move up and down with the economy as a whole) and replace it with the common stock of Hercules Gold Mining, Inc. (whose shares tend to rise when the economy falls and vice versa). Your portfolio's beta should:
decrease
Which is true about the measure of risk?
describe how certain, or uncertain about an expected (future) return summarize how far away the actual returns in each outcome are from the expected return
The reduction in risk that is accomplished by combining stocks in a portfolio is called __________________
diversification
straight-line voting
each candidate for the board of directors is elected by a majority vote. Therefore, any voting block which controls 51% of the votes will be able to elect all board members. This method tends to favor large blockholders at the expense of small shareholders.
The term required return is usually applied to
equity instruments such as common stock; the cost of funds obtained by selling an ownership interest.
News that has been "discounted" by the market is reflected in the ________ portion of the total return.
expected
true or false: Suppose you have an investment in a stock that had a negative 50% return (a loss) in the first year and a positive 50% return (a gain) in the second year. The geometric returns is 0%
false
true or false: municipal bonds or "munis" are risk-free
false
What are the possible patterns for future dividends? Check all that apply.
grow at a changing rate constant over time grow at a constant rate decrease at a constant rate
If the Federal Reserve took action to increase interest rates, a firm's cost of capital would _____________________ ceteris paribus.
increase
You have a portfolio that consists of equal amounts of IBM stock and Treasury bills. If you replace one-third of Treasury bills with more IBM stock , the expected portfolio return will ______, ceteris paribus.
increase
Behavioral finance
is a growing body of research that focuses on investor behavior and its impact on investment decisions and stock prices. Advocates are commonly referred to as "behaviorists" who argue that understanding human behavior and biases helps us to understand markets.
Risk
is a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset.
expected return
is defined as the probability-weighted return and is designated as E(R): Expected return: E(R) = ∑𝑛𝑖=1𝑝𝑖𝑅𝑖
Board of Directors
is the committee that hires, evaluates, and monitors the senior managers of the firm. Voting can happen in person at the shareholders' annual meeting
The expected return
is the return that appears to be available based on information about a firm's securities.
The required return
is the return that investors demand in order for them to be willing to buy securities from a firm.
Anchoring
is the tendency of investors to place more value on recent or even irrelevant information. Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions.
Confirmation bias
is the tendency to interpret new evidence as confirmation of one's existing beliefs or theories.
Expectations theory
is the theory that the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward-sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve.
Return
is the total gain or loss experienced on an investment over a given period of time; calculated by dividing the asset's cash distributions during the period, plus change in value, by its beginning-of-period investment value.
variance
is usually represented by the symbol σ2
Preferred stock generally makes a fixed dividend payment (like the interest payment on a bond) but with no ___________ date (like common stock).
maturity
Capital Asset Pricing Model
method for estimating expected stock returns based on a measure of how the individual stock contributes to the risk of a portfolio.
State and local governments also issue bonds called __________
municipal bonds or "munis"
In order to maintain their voting power, shareholders often get the first chance to buy any additional shares that the firm may issue, before they are sold to the public. This right to buy additional shares is called ________________
preemptive right
is closely related to regret theory and suggests that people express a different degree of emotion toward gains than losses.
prospect theory
Allowing someone else to vote one's shares is called _____________
proxy voting
What do companies do with excess cash flows generated by their operations?
reinvest in the firm cash payment in a form of dividend to shareholders
cost of capital
represents the firm's cost of financing and is the minimum rate of return - the hurdle rate - that a project must earn to increase firm value.
__________________ is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk.
risk averse
Bonds which are paid first are referred to as _______ and bonds paid afterward are called junior or subordinated
senior
weight for debt:
𝐷/𝑉 where D is the market value of all bonds issued by the firm.
dividend yield
𝐷1/𝑃0 it measures how much the dividend is, as a percent of the price.
weight for equity
𝐸/𝑉 where E is the total market value of all shares of common stock and V is the sum of the market values of all securities issued by the firm.
weight for preferred stock
𝑃/𝑉 The overall value of the firm is designated as V, so if the firm has common stock, preferred stock and bonds outstanding, then V would be: V = E + P +B.