FINC 341 Exam 2
Coupon Interest Rate
"CR"; designates coupon payment (CR * Par)
present value of an annuity due
"how much would you have to deposit today into an investment earning i% per year (with annual compounding) if you want your son to be able to withdraw $PMT at the beginning of each of the next n years?" PV of Annuity Due = (PV of Ordinary Annuity) (1 + i)
present value of an ordinary annuity
"how much would you have to deposit today into an investment earning i% per year (with annual compounding) if you want your son to be able to withdraw $PMT at the end of each of the next n years?" if n = 3: [ PMT / (1+i)^1 ] + [ PMT / (1+i)^2 ] + [ PMT / (1+i)^3 ]
future value of an annuity due
"if you deposit $PMT at the beginning of each of the next n years into an investment earning i% per year (with annual compounding), how much will you have at the end of the nth year?" (Annuity Due = payments are made at the beginning of each period). FV of Annuity Due = (FV of Ordinary Annuity)(1 + i)
future value of an ordinary annuity
"if you deposit $PMT at the end of each of the next n years into an investment earning i% per year, (with annual compounding) how much will you have at the end of the nth year?" (ordinary = payments are at the end of each period).
future value of a single sum
"if you deposit $PV today in an account paying i% (with annual compounding), how much will you have in n years?" PV(1 + i)^n = FV
present value of a single sum
"if you need to pay someone $FV in n years, how much would you need to deposit today in an account paying i% (with annual compounding) in order to have enough money in n years to pay your debt?" PV = FV / (1 + i)^n
stand alone risk
"the risk of an asset held by itself" is just one stock-do not ever put all of your money in a single stock, you need to diversify your portfolio so that you have less risk
years ago banks didnt have to reveal the rate tehy charged onc credit cards. then congress passed
"truth in lending" law that required them to publish APR.
uneven cash flows
"you are analyzing a project that has the following cash flows. If your required rate of return is i percent, what would you be willing to pay to invest in this project?" NPV(i, CF, {CF1, CF2, CF3, CF4})
EAR (effective annual rate)
"you have been offered i% compounded...(quarterly, monthly, or daily) (1 + (iNOM / M)^m)
Municipal Bonds
(munis) issued by state and local governments; have default risk (DRP); most are exempt from federal taxes so carry lower interest rates
unlike the portfolio return, the riskiness of a portfolio
(sigma sub p) is NOT the weighted average of the standard deviations of the individual assets in the portfolio. it is the weighted average of the squared deviations of K(sub)p from the expected K(sub)p-hat with the weights being the probability of each state of the economy occurring. direction of movement matters!!!!
Characteristics of Bankruptcy
- Federal Bankruptcy Statutes Govern Reorganization and Liquidation - Bankruptcies occur Often - Claims must be Prioritized correctly when Assets are Distributed - Bondholder's Treatment depends on the Terms of the Bonds - Stockholders usually receive little in Reorganizations, and usually nothing in Liquidations because the Assets are usually worth less than the Debt Outstanding
Open Market Operation
- If Fed sells Securities, it contracts the Money Supply, and increases Interest Rates - If Fed buys Securities, it expands the Money Supply, and decreases Interest Rates - Called "Quantitative Easing"
proxy
...
retirement security
..depends on: 1) rate of return on investments, 2) inflation, 3) diligence of saving money, 4) existence of social security, 5) life expectancy, and 6) health
if a stock is perpetual, g=
0
1 year bond vs. 18 year bond
1 year: price is fairly stable, no MRP. 18 year: price is volatile therefore more MRP
Federal Reserve Goals (2)
1) Achieve Full Employment - (defined as 5% or lower Unemployment) 2) Maintain Low Inflation
Methods for Valuating Stocks (2)
1) Discounted Dividend Model 2) Corporate Valuation Model
Macroeconomic Factors Affecting Interest Rates (4)
1) Federal Reserve Policy 2) Federal Budget Deficit/Surplus 3) International Factors 4) Business Decisions
Types of Yield Curves (3)
1) Normal 2) Inverted (Abnormal) 3) Humped
Factors Affecting Cost of Money (4)
1) Production Opportunities 2) Time Preferences for Consumption 3) Risk 4) Inflation
Determinants of Market Interest Rates (5)
1) Real Risk Free Rate 2) Inflation Premium 3) Default Risk Premium 4) Liquidity Premium 5) Maturity Risk Premium
two components of an asset's risk
1) diversifiable risk: "company specific risk" ex: when a company comes out with good shares 2) market risk (non diversifiable) ex: 9/11, when that happened EVERY stock went down
bond ranking criteria
1) financial ratios-ex: 20% debt ratio is better than 60% 2) bond contract terms 3) miscellaneous qualitative factors
Importance of bond ratings
1) since the bond's rating is an indicator of its default risk, the rating affects the bond's interest rate and the firm's cost of debt capital; 2) since most bonds are purchased by institutional investors that are restricted to investment grade securities, a firm will have a difficult time selling new bonds if it's bonds fall below BB
EAR
1+(1+inom/m)^m-1
Two components of an Asset's Risk
1. Diversifiable risk- Company specific risk 2. Market Risk - Non Diversifiable ex: 9/11 market dive, 08 crisis
The discount rate used is affected by:
1. The riskiness of the cash flows: default risk, maturity risk, and liquidity risk. 2.The level of interest rates in the current economy.
actions that make takeovers more difficult
1. electing only 1/3 of directors each year (to keep from having to complete takeover in 1 yr) 2. to require 75% of stockholders vote (rather than 50%) to approve of any merger 3. vote in a poison pill
for a stock to be in equilibrium what 2 conditions must hold
1. expected rate of return equals the required rate of return 2. the actual marker price must = the intrinsic value pf that stock based on future cash flows
when a us investor purchases foreign stocks what 2 things do you hope will happen
1. the stock will perform well in their local market (price increases) 2. the local currency increases in value relative to the dollar to allow more dollars to be purchased with the local currency
S &P 500 was____% before the tech bubble
24%
abby joseph from golden sachs said
40x P/E for all computer stocks
standard deviation numbers
68.3% lies within -+1 std. dev 95.5% lies within -+2 std. dev. 99.7% lies within -+3 std. dev.
Perpetuity
A steam of equal payments at fixed intervals expected to continue indefinitely
on 2-10-17 what happened?
Abby Joseph Cohen announced she is retiring, tech bubble burst after her words...she never talked about it on air
Takeover
Action when a person or group succeeds in ousting a Firm's Management and taking control of the Company
Loan Payment (Formula)
Actual PMT = PITI = Princ Int + Tax + Ins
Future Value (FV)
Amount to which a single or series of cashflows will grow to over a given period of time when compounded at a given rate
Effective Annual Rate (EFF% or EAR)
Annual Rate of Interest actually being Earned, as opposed to the Quoted Rate - Also called the "Equivalent" Rate
Annuity Due
Annuity whose payments occur at the beginning of each period
Ordinary (Deferred) Annuity
Annuity whose payments occur at the end of each period
Proxy Fight
Attempt by a person or group to gain control of a firm by persuading its Stockholders to gran that person or group the authority to Vote its Shares to replace current Management
Junk Bonds (high yeild)
BB, B, CCC, D Promoted by Michael Milken. Used by Ted Turner to finance the development of CNN and Turner Broadcasting. The junk bond market collapsed in the early 1990s but rebounded later. lots of risk
Yield of Treasury Bond
Benchmark of Security Yields, as T-Bonds have essentially no default or liquidity risk
If Rates have Risen
Bond prices will fall and firms will buy bonds in the open market at a discount
Premium Bond
Bond that Sells Above Par Value - Market Interest Rate is Lower than Coupon Rate
Discount Bond
Bond that Sells Below Par Value - Market Interest Rate is Higher than Coupon Rate
Capital Gains Yield
Bond's Annual Change in Price / Price at Year Start
Investment Grade Bonds
Bonds rated BBB or higher - Many Banks and other major Financial Institutions are permitted by Law to only hold these kinds of Bonds
Semiannual Coupons
Bonds that Disperse Coupon Payments twice a Year
Seasoned Issue Bond
Bonds that are Outstanding and are Re-Issued and Sold on the Public Market
New Issue Bond
Bonds that have been Issued for the first time - Often sell close to Par Value
Outstanding Bond
Bonds that have been previously issued
Corporate Bond Yield Spread (Formula)
C Bond Yield - T Bond Yield = DRP(t) + LP(t)
Yield of Corporate Bond (Formula)
C Bond Yield = r*(t) + IP(t) + MRP(t) + DRP(t) + LP(t) where t = number of years to maturity
Interdependency of Nation's Rates
Capital will seek out the Nation with the highest interest rates available, to maximize returns
Reorganization
Changes in the Organization and its Debt Restructure that allow it to continue operating
Debt Restructure
Changes in the nature of the Debt taken on by an Organization - Lengthening Maturity - Lowering Interest Rates - Exchanging Debt for Equity
Income Bonds
Characteristics of Bonds Bond that Pays Interest only if the Issuer has enough earnings to do so
Convertible Bond
Characteristics of Bonds Bond that can be exchanged for Common Stock from the Issuer at any time at Bondholder's Option (based on Open Market)
Warrant
Characteristics of Bonds Bond that can be exchanged for Common Stock from the Issuer at any time at Bondholder's Option, but the Stock to be sold is set at a fixed Price at Issuance of the Bond
Indexed (Purchasing Power) Bond
Characteristics of Bonds Bond that has Interest Payments based on an Inflation Index, to insulate holders from Inflation
Putable Bonds
Characteristics of Bonds Bonds that allow the Investor to Sell the Bond back to the Issuer at a pre-set Price
Other Features of Bonds
Characteristics of Bonds Convertible Bonds Warrants Putable Bonds Income Bond Indexed/Purchasing Power Bond
Maturity Date
Characteristics of Bonds Date on which the Par Value of a Bond must be Repaid
Original Maturities
Characteristics of Bonds Maturity of a Bond at the time of Issuance - as opposed to Remaining Maturity
Call Provision
Characteristics of Bonds Provision in a Bond that gives the Issuer the right to Redeem the Bonds under Specified Terms prior to the Normal Maturity Date
Sinking Fund Provision
Characteristics of Bonds Provision in a Bond that requires the Issuer to Retire of a portion of the Bond issued each year via Calling
Coupon Interest Payment
Characteristics of Bonds Stated Annual Interest Rate on a Bond
Par Value
Characteristics of Bonds Stated Face Value of a Bond
Call Premium
Characteristics of Bonds - Call Provision Additional Sum the Issuer must Pay to Redeem a Bond before Maturity - Often equal to one Year's Interest
Deferred Call
Characteristics of Bonds - Call Provision Bonds that cannot be Redeemed by Call for a minimum period of time
Call Protection
Characteristics of Bonds - Call Provision Bonds that have Deferred Calls have this Characteristic
Refunding Operation
Characteristics of Bonds - Call Provision When an Issuer releases new, lower Interest Rate Bonds (in a period of falling rates), and uses these capital funds to call older Bonds that have a higher Interest Rate
Original Issue Discount (OID) Bond
Characteristics of Bonds - Interest Bonds Originally Offered at a Price below its Par Value
Zero Coupon Bonds
Characteristics of Bonds - Interest Bonds that pay No annual Interest, but are sold at a discount below Par, to compensate in the form of Capital Appreciation
Fixed Rate Bonds
Characteristics of Bonds - Interest Bonds whose Interest Rates are Set for their entire life
Floating Rate Bonds
Characteristics of Bonds - Interest Bonds whose Interest Rates fluctuates and shifts in the general level of Interest Rates
Price/Reinvestment Risk Horizon
Components of Bond Risk Bond Type Price Risk Reinvestment Risk __________ ___________ ____________________ Long Maturity B High Low High Coupon B Low High
Reinvestment Risk
Components of Bond Risk Risk that a Decline in Interest Rates will lead to a Decline in Income from a Bond Portfolio
Default Risk
Components of Bond Risk Risk that the Issuer of a Bond will Default, and payments will not be fulfilled on the Bond
Price Risk
Components of Bond Risk The Risk of a Decline in a Bond's Price due to an Increase in Interest Rates - For Bonds with similar Coupons, the Longer the Maturity, the larger the Price Changes in response to a given Change in Interest Rates
Nominal Rate
Contracted Interest Rate - Also called "Quoted" or "Stated"
Interest
Coupon Rate x Par Value
Yield to Maturity
Current Yield + Capital Gains Yield (CY + CGY)
Horizon (Terminal) Date
Date at which the Growth becomes Constant - No longer necessary to forecast individual dividends
Cash Flow (CFt)
Designation of a Cashflow that is not part of an Annuity
Payment (PMT)
Designation of the equal Cashflows coming at regular intervals
Default Risk Premium
Determinants of Market Interest Rates (DRP) Premium that reflects the possibility that the issuer will not pay the promised interest or principle at the stated time - directly correlated with perceived risk of the security
Inflation Premium
Determinants of Market Interest Rates (IP) Rate equal to the average expected rate of Inflation over the life of the Security, which mitigates the losses that are incurred by inflation. It is not necessarily equal to the current inflation rate at the time of sale
Liquidity Premium
Determinants of Market Interest Rates (LP) Premium that reflects the cost of conversion of some securities, as some are more difficult to sell quickly than others
Maturity Risk Premium
Determinants of Market Interest Rates (MRP) Premium that reflects the risk of price declines due to increases in inflation and interest rates
Real Risk Free Rate
Determinants of Market Interest Rates (r*) The real rate of interest that would exist on a certain security in a world without inflation
Liquidation
Dissolution of an Organization characterized by the sale of its Assets
Semiannual Coupon Adjustments
Divide Annual Coupon Interest Payment by 2 Multiply Years to Maturity by 2 Divide the Nominal Interest Rate by 2
Dividends v Growth
Dividends are Paid out of Earnings Dividends Require Growth in Earnings Earnings Growth in long run because RE and Reinvest Higher RE, higher Growth Rate
Compounding Means Different Rates of Interest ______
Do not Equal Each Other
Proxy
Document giving one person the authority to act for another, typically the power to vote Shares of Common Stock
Components of Dividend Model (9)
Dt = Dividends Expected at Year End P0 = Market Price today P^t = Expected Price and Expected Intrinsic Value at Y end g = Growth Rate (Dividends) Rs = Required Rate of Return R^s = Expected Rate of Return R-s = Actual (Realized) Rate of Return D1/P0 = Dividend Yield (P^t -P0)/P0 = Capital Gains Yield Expected Total Return = r^s = Expected Div Yield (D1/P0) pluse Expected Capital Gains Yield [P^1 - P0)/P0]
If PMT does not = C/Y, P/Y, then match i to ________
EAR
EAR Formula
EAR = ( 1 + iNom/m)^(m) EAR = ( 1 + periodic rate)^(m) - 1
what is the most truthful rate?
EFF% because it is normally compunded on a monthly basis
Management's attempts to block takeovers
Elect only 1/3 of the directors each year; require 75% of stockholders to approve merger;
Continuous Compounding (Formula)
FV = PV(e^in) Where e=2.7183 Or let M be an arbitrarily large number (10,000)
continuous compounding
FV = PV(e^in) where e = 2.7183
Types of TVM Problems
FV Single Sum PV Singl Sum FV of Annuity - Ordinary, Due PV of Annuity - Ordinary, Due Valuation of a Perpetuity Valuation of Uneven Cashflows Compounding more often than Annually Nominal v Effective Annual Rates Amortization Schedule
Future Value of an Annuity Due (Formula)
FVAdue = FVAordinary(1+i)
Interest Rate Formula
FVn = PV ( 1 + iNom/m)^(mn) FVn = PV (1 + periodic rate)^(mn)
Future Value (Formula)
FVn = PV(1 + i)^n
Sinking Fund Provision
Facilitiates orderly retirement of the bonds 1. Certain percentage of randomly chosen bonds retired each year OR 2. certain amount bought on the open market.
Inflation
Factors Affecting Cost of Money Amount by which Prices will increase over time
Production Opportunities
Factors Affecting Cost of Money Investment Opportunities in productive (cash-generating) Assets
Time Preferences for Consumption
Factors Affecting Cost of Money Preferences of consumers for current consumption, as opposed to saving for future consumption
Risk
Factors Affecting Cost of Money The chance that an investment will provide a low or negative return
A bond with an S&P rating of BBB would be classified as a junk bond.
False - A bond with an S&P rating of AAA, AA, A, or BBB are classified as investment grade bonds. BB or below are classified as junk bonds.
A decrease in interest rates will cause the price of outstanding bonds to fall.
False - A decrease in interest rates will cause the prices of outstanding bonds to increase.
An IPO, initial public offering, would take place in the secondary market if the firm has already sold previous issues of its stock on the market.
False - An IPO (initial public offering) always takes place on the primary market. Furthermore, the firm couldn't have previously issued stock; if they had, it wouldn't be an initial public offering.
An IPO, initial public offering, would take place in the secondary market if the firm has already sold previous issues of its stock on the market.
False - An IPO would take place on the primary market ALWAYS. In addition, an IPO is an initial offering, therefore the firm wouldn't have sold any previous issues of stock. If they had, it wouldn't be an IPO.
As the discount rate increases without limit, the present value of a future cash inflow approaches infinity.
False - As the discount rate increases without limit, the present value of a future cash flow approaches zero.
You would rather be invested in an account that pays you interest compounded quarterly than one that pays interest compounded monthly.
False - Compounding more frequently will always yield a higher future value. Therefore you'd rather have monthly compounding rather than quarterly if you are earning interest.
If a bond gets called (because of a sinking fund provision) that has a coupon rate that is less than the current interest rate on similar bonds, the bondholder was actually hurt by the sinking fund provision rather than protected.
False - If a bond gets called with a lower coupon rate than the current interest rate, investors will be able to reinvest their money at the higher interest rate so they aren't hurt by the call provision, rather they are protected.
If a company's bonds are selling at a premium, the current yield (CY) will be below the expected rate of return for the year since the expected capital gains yield will be positive.
False - If a bond is selling at a premium (an amount above $1,000), the bond's price will decrease each period until maturity (at which time it will equal $1,000). If a price of a bond is decreasing, this is referred to as a negative capital gain yield.
Generally, stocks of smaller privately-owned firms are not listed on an exchange; they trade in the over-the-counter (OTC) market, and the companies and their stocks are said to be unlisted.
False - If a firm is privately owned, this means they are not traded at all, and they are not owned by the public. This would have been correct has is said "stocks of smaller publicly-owned firms are not....".
When the expected rate of return on a stock is greater than the required rate of return, demand for the stock will decrease and the stock price will fall.
False - If the expected rate is greater than the required rate, this is an attractive stock. Demand to purchase that stock will increase which will cause the price to increase.
When the expected rate of return on a stock is less than the required rate of return, investors will try to purchase shares of the stock; this will drive the price upward.
False - If the expected rate is lower than the required rate, this is not an attractive stock. Investors will not want to purchase the stock, rather they will want to sell it; which will drive the price down (because no one will want to purchase it unless it is cheaper).
If the expected rate of return on a stock is less than the required rate of return, stockholders will want to sell the stock and there will be a tendency for the stock price to increase.
False - If the expected rate of return is less than the required rate, this is not an attractive stock. Investors will want to sell the stock and the stock price will have a tendency to fall.
Long-term treasury bonds do not fluctuate when interest rates change because the U.S. Treasury has no risk of defaulting.
False - Long-term treasury bond prices do fluctuate because they still have risk associated with inflation and length of time to maturity.
Long-term Treasury bond prices do not fluctuate when interest rates cahnge since the U.S. Treasury has no risk of defaulting.
False - Long-term treasury bonds still have risk associated with Inflation and length of time to maturity. Therefore, prices of treasury bonds do fluctuate.
Preemptive rights give the management of a firm first right of refusal to buy the company's stock in an initial public offering (IPO)
False - Preemptive rights give the stockholders first right of refusal if additional shares are issued. This allows them to maintain their current ownership (if they desire) to prevent dilution of value. In addition, an IPO would be the first issuance of stock and there are no public stockholders before an IPO.
If a firm's earnings per share grew from $1.50 to $3 over a 5-year period, the total growth would be 100%, and the annual growth rate would be 20% compounded annually.
False - The annual growth rate would be less than 20% (in this case, 14.87% ← solved with TVM)
If a firm's earnings per share grew from $1 to $1.50 over a 10-year period, the total growth would be 50%, and the annual growth rate would be equal to 5%.
False - The annual growth rate would be less than 5% (specifically, 4.14% ← solved in TVM)
In an amortized loan, the payment of interest is smallest in the first payment, and increases with each payment thereafter.
False - The payment of interest is largest with the first payment, and decreases with each payment thereafter.
When U.S. investors purchase foreign stocks, they hope (1) that the foreign stock prices will increase in their local market and (2) that the foreign currencies will weaken relative to the U.S. dollar.
False - They are hoping foreign currencies will strengthen relative to the dollar. The first statement was true, however.
The nominal rate, the periodic rate, and the effective rate cannot all be equal.
False - They can be equal, but only if compounding is annual.
Floating coupon bonds pay no coupons at all, but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income.
False - This is describing a Zero Coupon Bond, not a Floating coupon bond. A floating coupon bond's coupon interest payments float with the going interest rate. That is, they increase if going interest rates increase, and they decrease when going interest rates decrease. A fixed coupon bond pays a fixed amount of interest every period regardless of the going market rate of interest at the time.
Having the proxy right to purchase any additional shares sold by the firm protects common stockholders from dilution of the value of their stock ownership prior to the new stock issue.
False - This is referred to as the preemptive right, not the proxy right.
Zero coupon bonds provide low interest income rather than capital appreciation.
False - Zero coupon bonds provide no interest income, only capital appreciation
You would rather be invested in an account that pays you interest compounded monthly than in one that pays interest compounded daily.
False - compounding more frequently will always yield a higher future value. Therefore, you'd rather be invested in an account that compounds daily than one that compounds monthly.
When investing overseas, you are betting that foreign stock prices will increase in their local markets, and that the currencies in which you will be paid will fall relative to the dollar.
False - everything is correct except you are betting currencies you will be paid in will strengthen relative to the dollar.
A dollar in the future is worth more than a dollar today.
False - if you receive a dollar today, you can invest that dollar and it will grow each period. Therefore, the sooner you receive an amount, they more return you will yield. A dollar today is worth more than a dollar in the future.
In an amortized loan, the payment of principal is largest in the first payment, and decreases with each payment thereafter.
False - payment of principal is smallest in the first payment and increases with each payment thereafter.
The nominal rate, the periodic rate, and the effective rate can all be equal when compounding is semiannual and the payments are made semiannually.
False - they will only all be equal when compounding is annual.
Bond Rating Criteria
Financial Ratios Qualitative Factors: Bond Contract Terms - Major Characteristics of a Bond - Maturity/Rate/Mortgaged or Not/Sinking or Not - Restrictive Covenant: Promise of the Issuer to meet other criteria (such as maintaining a certain Ratio at X) Miscellaneous Qualitative Factors - Other Factors about the Issuer and it's Industry
Bond Rating Criteria
Financial Ratios, Bond Contract Terms, Miscellaneous Qualitative Factors
FVAn
Future Value of an Annuity over N periods
Federal Reserve Requirement
Government mandated minimum of capital all banks must keep on hand at all times, and therefore cannot lend out - If Rate increased, it contracts Money Supply, and raises Interest Rates - If Rate decreased, it expands Money Supply, and lowers Interest Rates
Yield Curve
Graph that depicts the relationship between Bond Yields and Maturities
Junk Bonds
High-Risk, High-Yield Bonds
Discount Rate (kd)
Interest Rate charged by Banks to lend to other Banks - Paid in advance (taken off purchase value) - If Raised, it contracts Money Supply, and increases Interest Rates - If Lowered, it expands Money Supply, and decreases Interest Rates
Bond Ratings (Categories)
Investment Grade Junk
market risk premium is the same thing as
Km-Krf
Investment Horizon
Length of Time an Investor Plans to hold a particular Investment
Options upon Insolvency
Liquidation Reorganization
Amortized Loan
Loan that is repaid in Equal Payments over its life
Bond
Long term Debt Instrument used to raise capital
discount bond
MR>CR caused the bond to sell below par value
Quoted Rate of Interest
Market Interest Rates (r) Nominal Interest Rate of a Security as listed on the document
r(RF) Formula
Market Interest Rates r(RF) = (r*)+(IP)
r(RF)
Market Interest Rates r(RF) Quoted Rate of Interest for a Risk Free Security. Takes into account inflation r(RF) = (r*)+(IP)
Semiannual Compounding
Mathematical Process of determining the final Value of a Cashflow or series of Cashflow when Interest is added twice a year
Annual Compounding
Mathematical Process of determining the final Value of a final Cashflow or series of Cashflows when Interest is added once a year
Compounding
Mathematical process of determining the final value of a single or series of cashflows when compound interest is applied
Yield of Corporate Bond
Measurement of Security Yields, as the range of securities issued by corporations
Corporate Bond Yield Spread
Measurement that compares the risks involved in Corporate issued Securities as compared to those issued by the US government - Indicates that the increased Interest Rates on Corporate Securities is based upon their inherent risk of default and security, which is not present in US-backed Securities
Types of Corporate Bonds
Mortgage Bond Debentures Subordinated Debentures
Bond Valuation Components (Calculator)
N: Number Periods until Maturity Remaining I/YR: (Rd) Market Interest Rate of the Bond PV: Present Value of Bond PMT: Payments of Interest (typically each year) FV: Future Value of Bond
TVM Solver Componenents
N: Number of Periods I/YR: Interest Rate Per Period PV: Present Value PMT: Payment FV: Future Value
Uneven Cashflows (Calculator) Solution
NPV (Net Present Value) NPV = (Required Return, CF concurrent w/ NPV, {CF1, CF2, ect},{#Frequencies CF1, CF2, ect})
Interest Rate must match __________________
Number of Periods
JC Penny
On 9-26-13 price of JCP stock was $10.50; on 9-27-13 price was down to $9.50. They accounted issue of $84m in new stock - lowers EPS and price by 20%, shares are up 1/3
Present Value (Formula)
PV = (FVn)/(1+i)^N
continuous discounting
PV = FV / e^in where e = 2.7183
Continuous Discounting (Formula)
PV = FV/(e^in) = FV(e^in) Where e=2.7183 Or let M be an arbitrarily large number (10,000)
Perpetuity (Formula)
PVt = PMT(t+1)/(k-g)
Characteristics of Bonds
Par Value Coupon Interest Rate Maturity Date Call Provisions Sinking Funds Misc
M
Par Value (Maturity value)
Supernormal (Nonconstant) Growth
Part of a Firm's Cycle in which it grows much faster than the Economy as a whole
Payment Period or Compounding Period dictate Calculator?
Payment Period
Income Bond
Pays interest only if the interest is earned (higher coupon rate)
Loan Amortization Schedule Spreadsheet
Period | Beg Bal | Pmt | Int PMT | Princ PMT | End Bal = X + Y [ (i/m)(beg bal) ]
Annual Percentage Rate (APR)
Periodic Rate Times the Number of Periods per Year
PVAn
Present Value of an Annuity over N Periods
Risk Components to Bonds
Price Risk Reinvestment Risk Default
Discounting
Process of finding the present value of cash flow or a series of cashflows - Reverse of Compounding
Preemptive Right
Provision in Corporate Charter or Bylaws that gives Common Stockholders the Right to Purchase on a Pro Rata basis new Issues or Common Stock (or Convertible Securities)
Interest Rate (Formula)
Quoted Interest Rate = r = r* + IP + DRP + LP + MRP or (since r(RF) = r* + IP) Nominal Rate = r = r(RF) + DRP + LP + MRP
Opportunity Cost
Rate of Return an investor could earn on an alternative investment of similar risk
Yield to Maturity (YTM)
Rate of Return on a Bond if it is held until Maturity - Equals Expected Rate of Return only when: 1) Probability of Default is Zero 2) Bond Cannot be Called
Yield to Call (YTC)
Rate of Return on a Bond when it is Called before it's Maturity Date
Bond Valuation Components
Rd: Market Rate of Interest N: Remaining Periods until Maturity INT: Interest Payments Made M: Maturity (Par) Value of Bond
Term Structure of Interest Rates
Relationship between bond yields and maturities
Marginal Investor
Representative Investor whose actions reflect the belief in market currently trading stock - they determine the price
Exchange Rate Risk
Risk that Exchange Rates between Currencies will fluctuate - When that area destabilizes, capital flees, harming exchange rates
Country Risk
Risk that arises from investing in a foreign nation tied to their social, economic, natural, ect. risk of business disruption and default
Annuity
Series of Equal Payments at fixed Intervals for a specified number of periods
Uneven (Nonconstant) Cash Flows
Series of cash flows where the amount varies from one period to the next
Stock
Shares of Ownership of an organization, claims against the Assets used and owned by the organization
Par Value
Stated face value of the bond; usually $1000 in this class
Ways to Solve Cashflow Problems
Step By Step Approach - Doing each calculation individually on a timeline Formula Approach - Applying an algebraic formula to determine the change Financial Calculator Approach - Using the TVM Solver Program on a calculator Spreadsheets - Using computer programs like Excel
Classified Stock
Stock Form to meet Special Needs, often relating to acquiring assets or maintaining management voting power via ownership
Founders Shares
Stock Owned by the Founders that enables them to maintain Control of a Company without having to own a majority of Stock
According to the S&P ratings, bonds classified as AAA, AA, A, or BBB are considered to be investment grade bonds, as opposed to being junk bonds (classified as BB or lower).
T
Yield of Treasury Bond (Formula)
T Bond Yield = r*(t) + IP(t) + MRP(t) where t = numbers of years to maturity
2.5% inflation rate right now per CPI
TRUE
Amortization Schedule
Table showing precisely how a loan will be Repaid, breaking down the payments and showing what proportion pays interest (debt servicing costs) and goes towards paying down the principal
Bond Valuation
The Present Value of the Cashflows expected from the Financial Tool
If Rates have Fallen
The firm will call the bonds.
Pure Expectations Theory
Theory that states the shape of the Yield Curve depends on investor's expectations about Future Interest Rates
Call Provision
These provisions give the issuing entity the right to all in a bond for redemption prior to the original maturity. A call premium is generally paid when a bonds is called. The call premium is usually equal to one year's interest if called in the first year then declines by INT/N each year after; May have deferred call protection.
Bond Yield
Total Realized Value from a Bond over its Useful Life - Types: Yield to Maturity, Yield to Call
Types of Bonds
Treasury Corporate Municipal Foreign
A bond with an S&P rating of B would be classified as a junk bond.
True
A change in the risk-free rate will alter the equilibrium price of a stock.
True
According to the stock valuation model presented in the textbook, the value that an investor assigns to a share of stock is independent of the length of time that investor plans to hold the stock.
True
All else equal, bonds with longer maturities have more interest rate (price) risk than do bonds with shorter maturities.
True
As the discount rate increases without limit, the present value of a future cash inflow approaches zero.
True
Assuming equal coupon rates, a 15-year original maturity bond with five years left to maturity has the same amount of interest rate risk as a 10-year original maturity bond with five years left to maturity.
True
Common stockholders often have the preemptive right to purchase on a pro rata basis any additional shares sold by the firm. This enables current stockholders to maintain control and protects current stockholders from dilution of stock value.
True
For bonds, price sensitivity to a given change in interest rates generally decreases as years remaining to maturity decreases.
True
Founders' shares are stock owned by the firm's founders that have sole voting rights but restricted dividends for a specified number of years.
True
If a bank uses quarterly compounding for savings accounts, the nominal rate will be less than the effective rate.
True
If a bond gets called (because of a sinking fund provision) that has a coupon rate that is greater than the current interest rate on similar bonds, the bondholder was actually hurt by the sinking fund provision rather than protected.
True
If a bond is selling at a discount to par (below $1,000), its current yield will be less than its yield to maturity.
True
If a bond is selling at par value, its current yield equals its yield to maturity.
True
If a firm's earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%.
True
If a stock's dividend is expected to increase at a constant growth rate of 5%, it can be concluded that the price of the stock next year (P1) will be 5% higher than the current year (P0).
True
If a stream of cash flows is discounted back to t=0 using a 0% discount rate, then the PV of the cash flow stream is simply the sum of the cash flows.
True
If an account is compounded annually, the nominal rate will equal the effective rate.
True
If current interest rates are below an outstanding callable bond's coupon rate, then that callable bond is likely to be called, and investors will estimate its expected rate of return as the yield to call rather than as the yield to maturity.
True
If interest rates fall, bondholders of callable bonds are exposed to reinvestment rate risk because the bonds they hold may be called and that money will have to be put into new investments.
True
If investors become more risk-averse, the equilibrium price of a stock will change.
True
If the current kd for bonds stays constant from now until a particular bond matures, and that bond is currently selling at a premium on the secondary market, that particular bond will have a negative capital gain (i.e. capital loss) each year until it matures.
True
If the current kd for bonds stays constant from now until a particular bonds matures, and that bond is currently selling at a premium on the secondary market, that particular bond will have a negative capital gain each year until it matures.
True
If the expected rate of return on a stock is less than the required rate of return, investors will desire to sell the stock; there will also be a tendency for the price to decrease.
True
Ignoring interest accrued between payment dates, if the going rate of return on a bond is less than a bond's coupon interest rate, and kd remains below the coupon rate of that bond until maturity, then the market value of that bond will be above its par value until the bond matures, at which time its market value will equal its par value.
True
It is not correct to compare or combine values at different points in time.
True
Only at the equilibrium price, where the expected and required rates of return are equal, will the stock price be stable.
True
The current value of a share of stock is independent of the length of time that an investor plans to hold the stock.
True
The difference between an annuity and a perpetuity is that an annuity ends after some fixed number of payments.
True
The effect of earning interest on interest is known as compound interest.
True
The higher (better) the rating on a bond, the lower is the default risk and hence the lower is the required rate of return.
True
The price of a bond moves in the opposite direction as interest rates; for example, if interest rates rise, bond prices on the secondary market will fall.
True
The price of existing bond moves in the opposite direction as interest rates; for example, if interest rates rise, bond prices on the secondary market will fall.
True
The process of moving a value or cash flow backward in time is known as discounting.
True
The value of a perpetuity decreases when the required rate of return increases.
True
When U.S. investors purchase foreign stocks, they hope (1) that the foreign stock prices will increase in their local market and (2) that the foreign currencies will increase relative to the U.S. dollar.
True
When the going rate of return on bonds equals a fixed-rate bond's coupon rate, that bond's current value is equal to par regardless of years to maturity remaining.
True
Zero coupon bonds provide capital appreciation rather than interest income.
True
Corporate Bonds
Types of Bonds Bonds issued by private sector Corporations
Foreign Bonds
Types of Bonds Bonds issued by Foreign Governments and Corporations
Municipal Bonds
Types of Bonds Bonds issued by State and Local Governments
Treasury Bond
Types of Bonds Bonds issued by the US Government
Indenture
Types of Corporate Bonds - Mortgage Formal Agreement between Issuer and Bondholders
Junior Mortgage Bond
Types of Corporate Bonds - Mortgage Second set of Bondholders that are paid after Senior Mortgage Bondholders in the event of Liquidation and forced sale of the Fixed Assets backing the Securities
Senior Mortgage Bond
Types of Corporate Bonds - Mortgage First set of Bondholders that are paid first in the event of Liquidation and subsequent forced sale of the Fixed Assets backing the Securities
Subordinated Debenture
Types of Corporate Bonds; inferior to debenture Bonds having a claim on Assets only after Senior Debt has been paid in full in the event of Liquidation
Debenture
Types of Corporate Bonds; not secured, no collateral Long term Bond not Secured by a Mortgage on a Specific Property
Mortgage Bond
Types of Corporate Bonds; secured Bond backed by Fixed Assets as a Security - Can be Tiered (1st, 2nd Round Bondholders) - In Liquidation, 1st are paid, then on - 1st: Senior/First Mortgage Bonds - 2nd: Junior Mortgage Bonds
changes in ratings
US has no default rating, we got downgraded in crisis
Constant (Gordon) Model
Used to find the value of a constant growth stock
Corporate Valuation Model
Valuation model used to determine a Firm's value, especially one with no history of dividends, or a subsidiary/division - Calculates FCF, then PV to find Firm's Value
Horizon (Continuing) Value
Value at the horizon date of all dividends expected thereafter
Discounted Dividend Model
Value of Share consists of Expected Cashflows, of which there are 2: - Dividends Investor Receives Annually for Holding Stock - Price Received when Stock is Sold - Final Price includes Original and Capital Gain
Present Value (PV)
Value today of a future single or series of cashflows
Time Line
Visual tool in managing future and present value scenarios
Duration
Weighted Average of the Time it takes to Receive each of the Bond's Cashflows
Begin Mode
When Calculator is set to recognize an Annuity in which Payments are made at the Beginning of a Period (Annuity Due)
End Mode
When Calculator is set to recognize an Annuity in which Payments are made at the End of a Period (Ordinary Annuity); bonds are always in end mode
Business Decisions with Interest Rates
When I is up, Borrow Short Term, Invest Long Term When I is down, Borrow Long Term, Invest Short Term
Trade Deficit
When a Nation Imports more Goods than it Exports
Insolvency
When an Organization does not have enough Cash to meet Interest and Principal Payments on its Debt
Compound Interest
When interest is calculated and includes prior Interest earned
Single Interest
When interest is calculated on the Principal alone
Firing the Gun
When the Fed lowers Interest Rates
Loading the Gun
When the Fed raises Interest Rates
Humped Yield Curve
Yield Curve that has highest interest rates on intermediate securities (interest rates are highest on intermediate securities as compared to short term and long term)
Inverted (Abnormal) Yield Curve
Yield Curve that is downward sloping (interest rates decrease with length of time to maturity)
Normal Yield Curve
Yield Curve that is upward sloping (interest rates increase with length of time to maturity)
Types of Bond Yields
Yield to Maturity Yield to Call
Indexed (purchasing power) Bond
a bond that has interest payments based on an inflation index to protect the holder from inflation
floating rate bonds
a bond whos annual coupon payment is adjusted every 6 mo based on some going (market) rate of interest
inflation indexed bonds
a bond whose coupon interest payments rise as inflation rises to compensate investors for their dollar losing value. therefore the bond is indexed to the CPI consumer price index. The us treasury is the main issuer of these
a long term treasury bond has the same maturity risk as
a corporate bond with the same length of time remaining until maturity
debenture vs. mortgage
a debenture provides no specific collateral as security for the obligation; whereas a mortgage bond is backed by fixed assets (as security)
explain a dollar in hand today is worth more than a dollar to be recieved next year
a dollar heald today is worth $1, same as one recieved next year. but if you has the 1 today, you could invest it and earn interest on it. it would then be worth more than 1 at teh end of the year.
P/E ratio
a high P/E ratio does not necessarily mean a stock is overvalued; one drawback of using the P/E Multiple approach is that it depends on reported accounting earnings
Treasury-bond
a long-term Treasury bond with 8 years left will have the same maturity risk premium as a corporate bond with 8 years left; long-term Treasury bond prices fluctuate when interest rates change because the U.S. Treasury has some risk of defaulting; a long-term Treasury bond will have the same maturity risk as a corporate bond even though T-bonds are backed by the federal government
investment grade
a pension fund is only allowed to invest in BBB bonds or higher; not allowed to invest in BB or lower (junk)
define perpetuity
a perpetual (infinite) annuity. it's present value is found with a formula rather than a TVM calculation. it has no growth, g=0
valuation of perpetuity
a perpetuity is a infinite annuity. Its present value is found with a formula rather than a TVM calculation PVt = (PMTt+1) / (k)
poison pill provision
a poison pill provision allows the stockholders of a firm that is taken over by another firm to sell shares in the second firm at a lower price
standard deviation
a statistical measure of the variability of a set of observations
putable bonds
allow the investor to sell the bonds back to the company prior to maturity as a set price
putable bonds
allows investors to sell bond back to the company
Putable Bonds
allows investors to sell bonds back to the company. (Lower Coupon Rate)
investor playing the bond market
an investor playing the bond market would want to buy bonds when the going rate is high (buy at a discount) and then sell the bonds when the rate goes low (sell at premium) in order to get the highest rate
Effective Annual Rate (EAR)
annual rate that would produce the same end result as the per period interest rate
why would you rather recieve an annuity due than annuity
annuity due will yeild a greater FV because the money is recieved at the begining of every period, and we know that money is worth more today than it is a yr from not, then the annuity due will be more attractive.
maturity
any maturity is allowed. most range from 10-40 years
Maturity
any maturity is allowed; most range from 10-40 years
par value bond
any time the coupon rate on a bond matches the current going rate (market rate) on that type of bond, the bond's value is par; no matter how long is left on the life of a bond, when the going rate of return on bonds of that risk level equals that bond's current rate, that bond's current value will be par
simple interest
applied based only on the orginal cash amount
compounding
applying interest to a cash amount each year. each year interest is reapplied on the new total
dividends on stock
are not required, they are at the discretion of the companys board of mgmt. SH assume the company will do well enough to pay dividends and allow the stock price to increase ( captial gain)
an annuity due is in ____ mode
begin
"average stock" means
beta=1
putable bonds
bond that allows investors to sell bond back to company (less risk, lower i)
bond ratings (default risk)
bonds are rated investment grade (AAA, BBB, etc.) vs. junk bonds (BB, CCC, etc.); importance of ratings: 1) since the bond's rating is an indicator of its default risk, the rating affects the bond's interest rate and the firm's cost of debt capital. 2) Since most bonds are purchased by institutional investors that are restricted to investment-grade securities, a firm will have a difficult time selling new bonds if its bonds fall below BBB. Bond rating criteria: 1) Financial Ratios, 2) Bond Contract Terms, and 3) Miscellaneous Qualitative Factors
what are 2 ways sinking funds can be handeled
bonds can either be called back on the open market or called for redemption at a set price. bonds will be called on the open market if interest rates have risen, causing the bonds to sell at a discount on the open market if interest rates have fallen, the bonds will sell at a premium on the open market so they will prob be redeemed from the bondholder directly
treasury bond
bonds issed by the us treasury - very little risk - no DRP and LP
corporate bonds
bonds issued by corporations, have default risk, liquidity risk and maturity risk
foreign bonds
bonds issued by foreign governments or corporations, have default risk, maturity risk, and exchange rate risk
municipal bonds
bonds issued by state and local governments, have default risk and liquidity risk. Most are exempt from federal taxes so carry lower interest rates
treasury bonds
bonds issued by the federal government, no default risk or liquidity risk but do have maturity risk (interest rate risk)
foreign bonds
bonds issued by the foreign govs or corporations
corporate bonds
bonds issued y a corp. more risky than treasury bonds
convertable bonds
bonds that can be exchanged for share of stock in the company, this is at the option of the investor
zero coupon bonds
bonds that offer no interest payments. to compensate investors, these bonds where sold well below their par value. these types of bodsn dont have interest income (CY) but rather the value their bond increases each year to maturity (CGY)
income bonds
bonds that pay interest only if the company earns interest. income bonds cannot bankrupt a company but are seen by the investor to be more risky
types of common stock
classified stock, founders' shares
type of corporations
closely held corporations and publicly owned corporations
b
company beta which is the measure of relative risk
convertible bonds
convertible into shares of common stock at a fixed price, at the option of a bondholder; lower CR because its desirable
Convertible Bonds
convertible into shares of common stock, at a fixed price at the option of the bondholder; lower coupon rate.
convertible bonds
convertible into shares of common stock, at a fixed price, at the option of the bondholder; lower coupon rate (not as much interest but if stocks take off you can profit greatly)
a bond is a
debt instrument
as interest rates increase, the PV amount you need to be in the acct today
decreases because the money will grow faster
janet yellen
defended dodd frank bill by saying it was necessary to get banks back into a state of health
what are the benefits of adding foreign stocks
diversification. even the most diversified are still victims of market risk therefore every stock would move to some extent with the market. by diversifying in foreign stocks, those stocks move with the local market, which may or may not be in movement with the US- thus causing further diversification, reducing the market risk
march 1, 2017
dow went above 21000 for the first time ever bc Trump gave speechmaking people believe he will get stuff done
managements attempt to block takeovers
elect only 1/3 of the directors each year require 70% (rather than 50%) of stockholders to approve merger vote in poison pill provision (allows stockholders to buy takeover firm's shares at reduced price) stockholders do not want barriers to protect incompetent managers: SEC ruled in 1993 that large investors may work together now to affect management decisions
an ordinary annuity is in ____ mode
end
sinking fund provision
facilitates orderly retirement of the bonds - handled two ways: 1) certain percentage of randomly chosen bonds retired each year, or 2) certain amount bought on the open market - if i-rates have risen, causing bond prices to fall, the firm will *buy* bonds in the open market at a discount; if i-rates have fallen, it will *call* the bonds
sinking fund provision
facilities orderly retirement of the bonds; handled 2 ways: 1) certain percentage of RANDOMLY chosen bonds (call on a computer) retired each year, or 2) certain amount brought on the open market-if rates have risen, causing bond prices to fall, the firm will buy bonds in the open market at a discount; if rates have fallen, it will call the bonds
preferred stock has a
fixed dividend that must be paid before dividends can be paid on the common stock
floating bonds
floating coupon bonds do pay annual interest payments; floating coupon bonds always have a value equal to par
what is interest rate risk?
fluctuation. CR line is straight and horizontal and Kd line is wavy
foreign bonds and stocks
foreign bonds have default risk, liquidity risk, exchange rate risk, and maturity risk; when U.S. investors purchase foreign stocks, they hope 1) that the foreign stock prices will increase in the foreign country's local market and 2) that the foreign currency will strengthen relative to the U.S. dollar
callable bond
gives the option of the compnay to buy bonds back from the investor
if stocks are overvalued then investors should
hold the stock will sell it to realize the profit but no one will want to buy it because it costs too much relative to what it should. then the market price will fall bringing it to equiliruim
floating rate bond
i rate is tied to some rate such as the treasury bond rate. price=par
0% stream of cash flows
if a stream of cash flows is discounted back to t=0 using a 0% discount rate, then the PV of the cash flow stream is simply the sum of the cash flows
why do prices of fixed rate bonds fall if expectations for infaltion rise?
if inflation increases, it causes the dollar to be worth less. therefore a fixed amoutnt of interest is now worth less to an investor because the amount of interest pymts cant purchase as much as they could. since it is worth less, it will sell for less. also since inflation causes investors to want a higehr return and teh interest pymts are fixed, we must reduce the price to boost up the return
reinvestment rate risk
if interest rates fall, bondholders of callable bonds are more exposed to reinvestment rate risk; if interest rates fall, bondholders of callable bonds are also more exposed to interest rate risk
when comparing YTC and YTM
if the YTC is smaller than the YTM i and rates stay the same then the YTC will probably be called, but if the YTC is bigger and rates stay the same then it will not be called
capital gain
if the current Kd (yield to maturity) for bonds stays constant from now until a particular bond matures, and that bond is currently selling at a premium on the secondary market, that particular bond will have a negative capital gain each year until it matures; bonds selling at a discount have positive capital gains each year if constant
rates of return
if the expected rate of return is less than the required rate of return, stockholders will want to sell the stock and there will be a tendency for the stock price to decrease
amortized loan
in an amortized loan, the payment of principal is smallest in the first payment, and increases with each payment thereafter
why use preemptive rights
inhibits the company from issuing a large number of shares and management purchasing them all. this could allow mgers to seize control of the firm from the hands of the shareholders allows share holders to purchase more share in proportion of their current ownership. this prevents dilution of ownership and the value in the firm
bonds make money off of
interest and price. CY is interest and CGY is price
indexed (purchasing power) bond
interest paid rises automatically when inflation increases (ex: the U.S. treasury began issuing indexed bonds in January 1997 at 3.45% plus inflation (i.e. real rate of 3.45%)); protection is what retired people like because great safety feature
indexed bond
interest paid rises automatically when inflation increases (ex: the US Treasury began issuing indexed bonds in January 1997 at 3.45% plus inflation);
for S&P 500 which are "investment grade" and which are "High Yield/Junk Bonds"?
investment grade: AAA AA A BBB Junk bonds: BB B CCC D its very bad to go from investment to junk
if stocks are undervalued
investors will want to purchase the stock creating a huge demand for it, however the current stock holders will not want to sell it for a cheaper price so eventually the price will rise to meet equilbrium
the value of ANY asset
is the present value of its cash flows, using the appropriate required rate of return
Corporate Bonds
issued by corporations, have default risk and maturity risk (DRP & MRP)
corporate bonds
issued by corporations, have default, liquidity, and maturity risk
Foreign Bonds
issued by foreign governments or corporations; Have DRP, MRP and Exchange Rate Risk (fluctuation)
foreign bonds
issued by foreign govts. or corporations, have default, liquidity, maturity AND exchange rate risk
muni bonds
issued by state and local govts. have default and liquidity risk, most are exempt from federal taxes so they carry lower interest rates
treasury bonds
issued by the federal government, no default or liquidity risk, they do have maturity risk (i.e. interest rate risk)
Treasury Bonds
issued by the federal government; no default risk or LP but do have maturity risk (interest rate risk)
municipal bonds
issued by the state and local gov - interest recieved from holding this bond is NOT taxable
market value of equity
it follows that a company's market value of equity would be equal to the company's book value plus the present value of all future EVAs
what happens to EAR as you compound more frequently?
it goes up
what is the reason why constant growth rate=a stock's CGY?
its assumed that if the dividends increase by a certain percentage, that the stock price will increase about the same percentage
will finisih
later
bond
long term contract under which a borrower (a company) agrees to make payments of interest and principal on specific dates to the holders of a bond (investors)
when picking a stock based on CV, you would pick the one with the ______ CV
lower
market risk
market risk (also known as systematic risk) stems from factors such as war, recessions, and other macro factors, and cannot be eliminated
zero coupon bonds
means zero interest. pay no coupon payments, offered at a substantial discount so they have capital appreciation (capital gains) rather than interest income. these are more attractive to investors in high tax brackets
what type of risk are long term bonds more exposed to
more exposed to interest rate risk.
if interest rates fall, bondholders of callable bonds are
more exposed to reinvestment rate risk
key types of corporate bonds
mortgage, debentures, subordinated debentures
call provision
most corporate bonds have the right to call the bonds for redemption by paying the par value plus a call premium (typically = to one year's interest if called in the first year, then declines by INT/N each year thereafter); it may have deferred call (call protection)
call provision
most corporate bonds have the right to call the bonds for redemption by paying the par value plus a call premium (typically equal to one year's interest if called in the first year, then declines by INT/N each year thereafter); may have deferred call (call protection-promise not to call bond x number of years)
design a portfolio that reduces risk through
negative correlation of the stocks
r=0
no correlation
ordinary annuity
occurs when the payments are made at the END of each period
seasoned issue
once the bond has been issued and is outstanding for a period of time, it is referred to as a seasoned issue.
when to use TVM solver
only when there is a fixed amount of time involved and the payments are all equal
zero coupon bonds
pay no coupon payments; offered at substantial discount so have capital appreciation (tax is lower than interest=would rather have) rather than interest income
annuity due
payments are made at the beginging of each period
income bond
pays interest only if interest is earned (higher i)
r=-1
perfect negative correlation
r=+1
perfect positive correlation
if the current Kd (yield to maturity) for bonds stays constant from now until a particular bond matures, and that bond is currently selling at a discount on the secondary market, that particular bond will have a
positive capital gain each year until it matures
comounding
present value of a future amountis the amount which held today, would grow to become the future amount after applying interest each year * the act of finding the future value
types of stock market transactions
primary market, secondary market, going public, initial public offering (IPO)
bonds promise stocks promise
promise to pay interest provides an expectation of but no promise of dividends plus capital gain
junk bonds
promoted by Michael Milken the "King of Junk Bonds" in late 1970's, he was a major investor and went to the SEC and said people should have the right to buy risky bonds the government should not control keeping risky bonds off the market. The junk bond collapsed in the early 1990's but rebounded later and is here to stay; went to jail and now edu spokes person
Poison pill
provision states that if firm A was aquired by firm B, then firm A's stockholders would be entitled to purchase shares in acquiring firm (B) at a reduced price. this makes the aquistion less attractive and stops hostile takeover attempts
putable bonds
putable bonds contain provisions that allow the bonds' investors to sell the bonds back to the company
YTM
rate of return that you would earn if you held the bond until the maturity date.
YTC
rate you would earn if the bond was called
new issue
refers to an issue of bonds that has just occured
risk associated with short term bonds
reinvestment rate risk
k
required rate of return; "going rate"
Km
required return on an average stock in the market
preemptive right
right that existing shareholders have that if the firm issues new shares, they have the right to maintain their current percentage ownership before any share are allowed to be issued to the general public
Krf
risk free rate of return
if the expected rate of return on a stock is less than the required rate of return, stockholders will want to
sell the stock, and there will be a tendency for the stock price to decrease and the expected rate of return to increase
bonds with warrants
similar to convertibles; long term options which permit the bondholder to buy stock for a standard price; lower CR
Bonds with Warrants
similar to convertibles; options which permit the bondholder to buy stock for a stated price; lower coupon rate
what are the 2 parts of most stocks expected total return
since a stock can return money in dividends or by the stock price increasing, there are 2 parts to its total yield the money returned in dividends is called dividend yeild the increase in stock price from yr to yr is called the CGY
importance of bond ratings
since the bond's rating is an indicator of its default risk, the rating affects the bond's interest rate and the firm's cost of debt capital. since most bonds are purchased by institutional investors that are restricted to investment-grade securities, a firm will have a difficult time selling new bonds if its bonds fall below BBB.
why do most trades occur in the over the counter market
stocks are traded over the stock market because of the large number of large and small stockhodlers. bonds are traded OTC because they are owned and traded by large finc inst. and it is easier to arrange the transfer
if the bonds were selling at a discount
that would indicate that interest rates have increased. therefore the issuer would not be likely to call the bonds
intrinsic value is calculated as
the PV of all future dividends during the supernormal growth period plus the PV of the terminal value
how does the pv of a fv change as the time to receipt is lenghthened
the PV will decrease
SEC change
the SEC changed the rules in 1993 in order to allow large investors to work together to force management changes and increase the focus on stock price maximization
Fortune article
the US savings rate is the lowest of any industrial nation; the ratio of US workers to retirees is now 3.2 to 1, compared to 17 to 1 in 1950, and will be 2 to 1 after the year 2020; people earning 85,000 today will have trouble maintaining their standard of living in retirement
discounting
the act of finding the present value, taking interest out of a future amount to fidn out what it must have started out at
beta coefficient
the amount and direction of stock's movement compared to the market's movement is measured by its __. Thus, a stock's beta measures its contribution to the riskiness of a portfolio
if a bond is selling at a discount and the bond's YTM stays constant, then
the bonds price will be higher one year from now
when a bond issue is sold at par
the coupon rate must be set at the market(going) rate. company is willing to pat the same amount in coupon payments that the rest of the market is willing to pay.
stock value
the current value of a share of stock is unrelated to the length of time that an investor plans to hold the stock
you should not buy a stock if
the expected price is less than the equilibrium
would distant payments contribute more to the value of an annuity if interest ratees were high or low?
the further the payments occur in the future, the more interest is discounted out. If the interest rates are higher,more interest would have been discounted out leaving a lover PV. If the interest rates were lower, less interest would have been discounted out, leaving a higher PV
the more movement in beta,
the more risk
sensitivity to interest rates
the price of a bond with 9 years left to maturity has more sensitivity to a change in the interest rates than a bond with 5 years left
price of bonds
the price of bonds on the secondary market will increase if interest rates fall
in a addition to foreign risk, what key risk do investors in foreign bonds face
the risk that the US dollar will lose purchasing power realtive to the foriegn countrys currency (exchange rate risk)
the discount rate used is affected by
the riskiness of the cash flows-DRP, MRP(also known as the interest rate risk), and liquidity risk, and the level in interest rates in the current economy
to solve for the required return on stocks use
the securities market line equation
coefficient of variation
the standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return
the SML gets steeper when
the stock market gets riskier
the best measure of a stocks risk to a diversified investor is
the stocks beta
classified stock
the use of classified stock enables the company's founders to maintain control over the company without having to own a majority of the common stock; most firms do not have classified shares
value of perpetuity
the value of a perpetuity decreases when the required rate of return increases
bond valuation
the value of any asset is the present value of its cash flows, using the appropriate required rate of return. The discount rate is affected by: 1) the riskiness of the cash flows - DRP, MRP, and LP, and 2) the level of interest rates in the current economy PV = (PV of all Interest Payments) + (PV of Maturity Value)
the price of floating rate bonds remain equal to
their par value
why are treasury bonds not completly riskless
there is no DRP or LP, but there is still risk inherent to inflation or length of time to maturity
when interst rates fall reinvestment rate risk
there si a greater chance that bonds will be called by companies. the investors would then have to reinvest their money in another bond which pays less interest
APR and inom
they are the same thing. they refer to the interest rate that is quoted or stated on th face of loans, bonds and notes the only time to use this interest rate is when compounding is done once a year. if compoundign is done more, then you need to convert the APR to the interest period
qulalcomm
they declared a 4 for 1 split and Po went from $600/share to $150 per share
zero coupon bonds are desirable because?
they give capital gains that are not taxed at as high of a rate as interest income would be on a regular bond
chapter 7 (liquidation)
type of bankruptcy; assets are sold and the cash is distributed according to the priority of claims. The sequence of claims go to the secured creditors, trustees, expenses, and wages - common stockholders are last
chapter 11 (reorganization)
type of bankruptcy; value of the reorganized firm must be perceived as higher than if the firm were sold off piecemeal. Firm's debt may be restructured - 1) interest rate may be lowered; 2) term to maturity may be lengthened; 3) some of the debt may be exchanged for shares of stock (dilutes EPS); 4) trustee appointed to oversee reorganization
junk bonds
type of bond promoted by Michael Milken (of Drexel Burnham Lambert) in the late 1970s. Used by Ted Turner to finance the development of CNN and Turner Broadcasting. The junk bond market collapsed in the early 1990s, but rebounded later and is here to stay
type of investment: international small cap value index
undervalues due to assets etc.
when to use the gordon model
used for an infinte amount of periods. this model only solves the PV based on teh FUTURE cash flows. it doesnt include an cash flows that occur at t=0 (today) can be used when the payments are not equal
classified stock
usually designates one class to receive dividends and one class who receives no dividends but holds all control. usually for a set amount of time, like the 2st five years to make sure the control is in mgmt hands in the most crucial years
current event about oil
we have 489 rigs in the US, if we go down to 488 we will have the lowest amount of rigs since 1948
the expected return on a portfolio is the
weighted average of the expected returns on the individual assets in the portfolio, with the weights being the proportion of the portfolio invested in each asset
premium bond
when CR>MR bond sells above par value
Kevin O'leiry said
when a company reduces its dividend, that company goes through hell for two years. people worry about future cuts since that company is willing to cut dividends so people buy a different stock instead
interest rate risk
when an investor is holding bonds and the interest rate rises, the value of their bonds will decline
floating rate bond
when the interest rate is tied to some rate such as the Treasury bond rate
what is insolvency?
when you cannot pay your debts, whoever you owe can declare you are bankrupt, then you can go to the courts to try and negotiate lower rates
the return of a portfolio greatly depends on
whether the individual assets are positively correlated or not, and to what degree. positive correlation is the tendency of two variables to move together. the correlation coefficient, r, measures this tendency
if the equilibrium price of a stock (Po) is greater than the current selling price then
you should buy the stock because it is under valued for its risk level
zero coupon bonds
zero coupon bonds are more attractive to investors in high tax brackets; they pay no coupons at all, but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income
what type of secrutiy can minimize both interest rate risk and reinvestment rate risk for a fixed investment
zero coupon treasury bond with a maturity that matches the investment horizon
