Finance Final Exam (Ch 7, 8, 12, 13 Concepts)

Call Provision

- An agreement giving the corporation the option to repurchase a bond at a specified price (almost always larger than face value) prior to maturity - This is great for corporations - Bad for investors

Bond Debt Rating

- Based on how likely the firm is to default and protection creditors have in the event of default - Therefore, bonds with lower ratings should have higher yields

Repayment arrangments

- Bonds can be repaid: At maturity or In part or in entirety before maturity -Firm makes annual payments to the trustee, who then uses funds to retire portion of the debt

Interest Rate Risk for Long Term Bonds

- Change in price due to changes in interest rates - Prices will change because interest rates will change the rate at which we discount cash flows - Long term bonds have more price risk than short term bonds - Low coupon rate bonds have more price risk than high coupon rate bonds

Investors' protection against call provision

- Corporate bonds typically callable - Call premium: Difference between call price and stated value (par value) - Deferred call provision: Wait a certain number of years to call it back

As general proposition, the market risk premium should be

- Greater than zero - Increase with the risk aversion of the investors in that market - Increase with the riskiness of the average risk investment

Protective Covenants

- Part of the indenture limiting certain actions that might be taken during the terms of the loan - Usually to protect investors

Interest Rate Risk for Short Term Bonds

- Reinvestment Rate Risk - Uncertainty concerning rates at which cash flows can be reinvested - Short-Term bonds have more reinvestment rate risk than long term bonds - High coupon rate bonds have more reinvestment rate risk than long term bonds

Limitations of CAPM

- The model makes unrealistic assumptions - The parameters of the model cannot be estimated precisely - The market index used can be wrong - The firm may have changed during the estimation period - The model does not work well - A Lot of firms don't meet the green line - Relationship between betas and returns is weak

Treasury Yield Curve

- Used to gauge the term structure of interest rates - 3 key features: Default free, taxable, highly liquid -Based on coupon bond yields - The yield curve tends to be sharply increasing as the economy comes out of a recession and interest rates are expected to rise

What does CAPM Utilize?

-TVM of money -The reward for bearing systematic risk (market risk premium) -Amount of systematic risk

What 2 conditions are needed for a company grow?

1. It must not pay out all of its earnings as dividends all the time 2. Must invest in good projects

Based on the period 1926-2019, the actual real return on large-company stocks has been around:

9%

Designated Market Maker

A member who acts as a dealer in a limited number of securities on the floor of the NYSE

Current Yield

Annual Coupon / Bond Price

Which one of the following is the price at which a dealer will sell a bond?

Asked Price

What does Bond Indenture Include?

Basic terms Total amount issued Collateral Repayment arrangements Call provisions Protective covenants

Security (Collateral)

Collateral - Assets that are pledged as security for payment of debt (commonly used to asset pledges on a debt).

When Value = Principal,

Coupon Rate = Yield

Amount paid to bondholder each year

Coupon payment

YTM

Current Yield + Capital Gains Yield

Is Current Yield > or < YTM for discount bonds?

Current yield < YTM

Is Current Yield > or < YTM for premium bonds?

Current yield > YTM

Treasury Securities

Federal government debt

Relationship b/t geometric average and arithmetic average

Geometric average is less than arithmetic average when the stock has a loss, otherwise they are the same

Market Risk Premium

How much money we require the market to pay us to take on risk in that market

Market Equilibrium

In equilibrium, all assets and portfolios must have the same reward to risk ratio, and they all must equal the reward to risk ratio for the market (All assets will eventually fall on the green line).

Terms of a Bond

Includes Registered form (Ownership terms) and Bearer form

Is YTM for short or long term investors?

Long Term Investors

Which one of the following statements is correct based on the period 1926-2019?

Long-term government bonds had more volatile annual returns than did the long-term corporate bonds.

Municipal Securities

Lower yield because you don't have to pay taxes

Specified Date on which principal is repaid

Maturity Date

Which one of the following correctly describes the dividend yield?

Next year's annual dividend divided by today's stock price

Seniority

Preference in position over other lenders

If you expect interest rates to increase, should you worry about price or reinvestment risk?

Price Risk

Which one of the following rates represents the change, if any, in your purchasing power as a result of owning a bond?

Real Rate

If you expect interest rates to decrease, should you worry about price or reinvestment risk?

Reinvestment Risk

Slope of Market Risk Premium

Reward to Risk Ratio [E(Ra) - Rt] /Beta

Is current yield for short or long term investors?

Short Term investors

Theoretically, what are totally efficient stock markets?

Stock markets that have 0 NPVs for all stock investments.

According to the Dividend model, what is the price of the stock in dividend terms?

The PV of all expected future dividends

Which one of the following is the most likely reason why a stock price might not react at all on the day that new information related to the stock's issuer is released? Assume the market is semistrong form efficient.

The information was expected.

Bonds are generally a safer investment than stocks

True

Weak efficiency offers the greatest profit potential to an outstanding professional stock analyst.

True

Rate required in the market on a bond

YTM

Real Yield for Corporate Bond

Yield (Tax bracket - 1 )