Finance 408 quiz 4
how the market set stock prices are influenced by information?
Information is important for individuals to value each asset. When new information is released about a firm, expectations and prices change. Market participants constantly receive information and revise their expectations, so stock prices change frequently.
Prior to 2008, mortgage lenders required a house inspection to assess its value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?
Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.
what is the interest rate for a straight bond
Interest Rate = Instantaneous Rate + Default Premium +Maturity Premium
The theory of the term structure of interest rates must explain the following facts:
Interest rates on bonds of different maturities move together over time. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted. Yield curves almost always slope upward.
What will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future?
Interest rates on corporate bonds will decrease
Liquidity Premium & Preferred Habitat Theories
Interest rates on different maturity bonds move together over time; explained by the first term in the equation Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case Yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens
what is the preferred habitat theory?
Investors have a preference for bonds of one maturity over another. They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return. Investors are likely to prefer short-term bonds over longer-term bonds.
If junk bonds are "junk," then why would investors buy them?
Junk bonds can provide high yields
What would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market?
Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand, which would lower the risk premium
what is liquidation value?
Net amount realized from sale of assets and paying off all debt Firm becomes a takeover target if market value stock falls below this amount, so liquidation value may serve as floor to value
If the dividend and required return remain the same, and the stock price is expected to increase by $11 five years from now, does the current stock price also increase by $11?
No, the current stock price will not increase by $1 because the future stock price is discounted by the required return.
what is ratings shopping?
companies choose the best rating from usually two of the credit rating agencies
If investors develop a greater aversion to risk or view DuWop stock as having greater risk, k, the share price will
decrease
What is random walk?
describes movements of a variable whose future values cannot be predicted
needed another term to create
done
Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.
example of an important point about rational expectations
If DuWop announces an increase in the annual dividend, Div, the price of a share of DuWop will
increase
what is the concept of arbitrage?
where market participants eliminate unexploited profit opportunities
What can't we explain about yield curves?
why yield curves almost always curve up
What is the yield curve?
yield on short term/ long term bonds which generally have upward sloping curves
What is nice about zero coupon bonds?
ytm is always equal to the rate of return
According to the Gordon growth model of stock price determination, at what price should a stock sell for if the required return on equity investments is 12%, the stock will pay a dividend of $1.80 next year, and dividends are expected to grow at a constant rate of 3%?
$20 gordon growth model p=D1/(ke-g)
What are the three credit rating agencies?
-Moody's -Standard &Poor -Fitch
What is the Gordon growth model?
-assumes constant dividend growth -assumes that dividends are to continue growing at a constant rate forever -assumes the growth rate is assumed to be less than the required return on equity
What was good/bad about the original credit rating model?
-bad was the free rider problem some investors paid for ratings and others would get copies -good credit ratings were more accurate
What are problems with the new credit rating system?
-profits affect ratings -more favorable ratings for larger issuers, and more frequent issuers -larger issuers downgraded less often -ratings are more inflated during economic boom and more strict during recession
Bonds with the same maturity have different interest rates due to
-risk of default -taxes -liquidity
Suppose that a stock is expected to pay a $4 dividend next year, that the dividend is expected to grow at 3% per year, and that your required return on this equity investment is 7%. Using the Gordon growth model, the price you would be willing to pay for the stock is
100 gordon growth model p=4/(ke-g)
Using the Gordon growth model of stock price determination, if a share of stock will pay a $1 dividend next year, dividends are expected to grow 2%, and people require an 10% return on equity investments, then the price of the stock is $
12.5% gordon growth model p=D1/(ke-g)
Suppose that a stock is expected to pay a $1 dividend at the end of this year and that your required return on equity investments is 10%. Using a one-period model of stock price determination, if you expect to sell a stock you buy today a year later for $16.0, you will be willing to pay for the stock the amount?
15.45 p=(div1+p1)/(1+.ke)
Given that the price a stock is bought for is $110. Based on the one-period valuation model of stock prices, if the stock is sold a year later at the price $130 after receiving a dividend of $2, then the required rate of return on equity investments is? Now, suppose that the price of the stock above was bought instead for $115. Then, required rate of return on equity investments then
20% ke=(p1+D)/p0 -1 X100 decreased
Suppose that company YYY just paid a dividend of $10 per share. The dividends are projected to grow at 10% for the next two years. After that the earnings and dividends will remain constant forever. Draw a timeline showing the dividend payments. What is the value of YYY today if the required rate of return is 5%?
220
Using the one-period model of stock price determination, at what price should a stock sell for if the required return on equity investments is 8%, the stock pays a dividend of $0.50 next year, and the stock is expected to sell next year for $30?
28.24 p=(p1+div1)/(1+ke)
Compute the price of a share of stock that pays a $1.50 per year dividend and that you expect to be able to sell in one year for $30, assuming you require a 10% return.
28.64 pv=div1+fv of stock/(1+%)
Suppose that your marginal tax rate is 20%. Your after-tax return from holding (to maturity) a one-year corporate bond with a yield to maturity of 5% is what?
4% because r=(1-t)i
Using the one-period valuation model of stock prices, if a share of stock pays an annual dividend of $4, you require a 14.0% return on equity investments, and if you believe that you can sell the stock next year for $50, then you would be willing to pay for the stock the amount $?
47.37 p=(div1+p1)/(1+ke)
According to the expectations theory of the term structure of interest rates, if the one-year bond rate is 3%, and the two-year bond rate is 4%, next year's one-year rate is expected to be
5%
Suppose that you can buy a 2-year bond with i=5%. Alternatively, you can buy a 3-year bond that has i=6%. Which bond is better if you have $1,000 to invest? You expect that the interest rate between Year 2 and Year 3 is 9%. What is interest rate between Year 1 and Year 2 ?
5+5+9=19 6+6+6=18 choose 2 year bond and reinvest
Suppose that the price a stock is bought for is $125. Based on the one-period valuation model of stock prices, if the stock is sold a year later at the price $133 and the required rate of return on the equity investments is 11%, then the dividend paid out for the stock is? Suppose that the price a stock was bought for was higher than the one above. Holding every other variable the same, this implies that the dividend paid out for the stock is ▼ .
5.75 D=(P0 X(1+ke))-P1 higher
What is the expectations theory?
90% of the time expect interest rates to increase problem=fluctuation
Example: Suppose that the dividends of stock A grow at a stable rate g=0.05. The most recent paid dividend D0 was 3.81 and the required rate of return is 12%. What is the intrinsic value of the stock?
=57.15 gordon growth model intrinsic value P0=D0(1+g)/(ke-g)
After careful analysis, you have determined that a firm's dividends should grow at 5%, on average, in the foreseeable future. The firm's last dividend was $2.00. Compute the current price of this stock, assuming the required return is 10%.
?
what is the two stage growth model?
A company can grow exceptionally fast for a while, but at some point the company matures and its growth normalizes!
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt.
Suppose you observe a change in the relationship between short-term and long-term bonds. Specifically, you note that although interest rates on both short-term and long-term bond are rising together, as expected, the rate on long-term bonds is not rising by as much as has been observed in the past.
Assuming the liquidity premium theory of term structure, you conclude that the liquidity premium is decreasing As a result, the yield curve becomes flatter
What was one aspect of business for credit rating companies that dodd frank got rid of?
Before 2008 - CRA sold both advising (consulting) and ratings to bond-issuers
what is the segmented markets theory?
Bonds of different maturities are not substitutes at all. The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond. Investors have preferences for bonds of one maturity over another. If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3).
what is market value?
Current market value of assets minus current market value of liabilities Market value of assets may be difficult to ascertain Market value based on stock price Better measure than book value of the worth of the stock to the investor.
Identify the cash flows available to an investor in stock.
Dividends and capital gains.
What was the government answer to the 2008 recession
Dodd-Frank - more transparency, more reporting, separations between consulting and rating business; the effect is not clear - we know CRAs give generally lower ratings, and downgrade more; possibly to protect their reputation, avoid further government regulation; but ratings are not more precise!
how are the three theories used?
Expectations theory explains the first two facts but not the third. Segmented markets theory explains the third fact but not the first two. Liquidity premium theory combines the two theories to explain all three facts.
Trading signal based on fundamental value
Fundamental Value > Market Price →buy: underpriced stock Fundamental Value < Market Price →sell/short sell: overpriced stock Fundamental Value = Market Price →Hold: fairly priced stock
Suppose that you can buy a 1-year deposit with i=5%. Alternatively, you can buy a 2-year deposit that has i=7%. Which deposit is better if you have $1,000 to invest?
If you expect that the interest rate between Year 1 and Year 2 is 8%? If you expect that the interest rate between Year 1 and Year 2 is 6%? What interest rate between Year 1 and Year 2 will make you indifferent between the two deposits?
What are Pitfalls in Using P/E Ratios?
P/E - ratio of a stock's price to its earnings per share (accounting earnings, not economic earnings!) Earnings management is a serious problem!!! P/E should be calculated using pro forma earnings (estimated earnings). A high P/E implies high expected growth, but not necessarily high stock returns. All other things equal , riskier firms should have lower P/E ratios Simplistic, assumes the future P/E will not be lower than the current P/E. If expected growth in earnings fails to materialize the P/E will fall and investors may incur large losses.
What basic principle of finance can be applied to the valuation of any investment asset?
Present value
What is replacement cost?
Replacement cost of the assets less the liabilities May put a ceiling on market value in the long run because values above replacement cost will attract new entrants into the market. Tobin's Q = Market Value / Replacement Cost; should tend toward 1 over time.
What is the conflict for credit rating agencies in the current model?
Reputation vs profits- good reputation of accurate credit ratings for investors vs easier credit ratings for companies to increase profits
how to uncover mispriced securities?
Technical analysis - trend analysis Fundamental analysis - use information about current and prospective profitability of the company to estimate its fair market value
In which of the following situations would you choose to hold the corporate bond over the municipal bond, assuming that corporate and municipal bonds have the same maturity, liquidity, and default risk?
The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%
During 2008, the difference in yield (the yield spread) between 3-month AA-rated financial commercial paper and 3-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden increase?
The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.
Segmented markets
The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities.
what are Liquidity Premium & Preferred Habitat Theories
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond. Bonds of different maturities are partial (not perfect) substitutes.
what is the expectations theory?
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bond holders consider bonds with different maturities to be perfect substitutes.
according to the expectation theory what would the interest rate on a 2 year bond have to be to purchase it? Let the current rate on one-year bond be 8%. You expect the interest rate on a one-year bond to be 6% next year. Then the expected return for buying two one-year bonds averages (8% + 6%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be willing to purchase it.
Expectations theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.
Preferred habitat
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.
how the market sets stock prices
The price is set by the buyer willing to pay the highest price. The market price will be set by the buyer who can take best advantage of the asset. Superior information about an asset can increase its value by reducing its perceived risk.
what are the properties of the gordon growth model?
The stock price increases if the dividend increases. The stock price increases if the required rate of return decreases. The stock price increases if the growth rate increases. The stock price is expected to grow at the same rate as the dividends.
In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?
The yield and risk premium will fall since demand for AIG corporate debt will increase.
If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve?
The yield curve would become flatter
Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?
The yield curve would shift down, but mostly on medium- and long-term maturities.
How do short term and long term bonds move?
They generally move together
Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs?
Treasuries are considered to be risk-free debt instruments.
what is Book value?
Value of common equity on the balance sheet Based on historical values of assets and liabilities, which may not reflect current values Some assets such as brand name or specialized skills are not on a balance sheet Is book value a floor value for market value of equity?
Expectations theory explains:
Why the term structure of interest rates changes at different times. Why interest rates on bonds with different maturities move together over time (fact 1). Why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2). Cannot explain why yield curves usually slope upward (fact 3)
If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future?
You would raise your predictions of future interest rates.
What is residual claimant?
ability of shareholders to have claims on cash flows
What is behavioral finance?
applies concepts of social sciences to explain behavior of security prices
Why is volume not used as a measure of stocks?
because of high frequency traders which are 70% of trades
Why do Bonds with identical risk, liquidity, and tax characteristics may have different interest rates?
because the time remaining to maturity is different
What are default free bonds?
bonds with essentially no default risk ex: 3 month US treasury bonds
What are junk bonds?
bonds with ratings below baa and BBB which have a significantly higher defualt risk
What are short sales?
borrow stock from brokers and then sell it in the market with aim of making a profit
what are rational expectations?
expectations will be identical to optimal forecasts using all available information
If short term interest rates are higher in the beginning would you expect them to fall or rise?
fall
Which of the following would cause the risk premium on corporate bonds to rise?
fewer participants in the bond market causing reduction in transactions
What are mortgage backed securities?
financial engineering that selling bonds to investors that have a mix of safe and risky investments
what is the one-period valuation model
hold stock for one period to receive dividend then sell stock
Why might an investor choose a long term bond with a lower interest rate over a short term bond with a higher rate?
if interest rates are predicted to decrease short term bonds will be affected but long term bonds are fixed rate
Another way to state the efficient market condition is
in an efficient market, all unexploited profit opportunities will be eliminated
If investors expect an increase in the growth, g, of earnings and dividends over the next 5 years, the price of a share of DuWop will
increase
If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would
increase
What is credit default swap? (CDS)
insurance against default for bonds and is extremely liquid
Municipal bonds tend to pay lower interest rates than U.S. Treasury bonds because
interest payments received from holding municipal bonds are exempt from federal income tax.
What is the liquidity premium theory?
interest rates on long term bonds will equal the average of of short term interest rates expected to occur over the life of the long term bond plus a liquidity premium
What was the original system when credit ratings where established?-1975
investors pay credit rating agencies
What are market fundamentals?
items that have a direct impact on future income streams of the securities
When your required return on an equity investment increasesincreases, then according to the Gordon Growth Model you will be willing to pay ▼ more less the same for the investment.
less
When companies default what re paid first?
loans sr bonds . . . jr bonds
What bonds are attractive for people with high incomes?
local bonds because they are usually exempt from federal taxes
what happens during upward sloping on the yield curve?
long-term rates are above short-term rates
what happens when the yield curve is inverted?
long-term rates are below short-term rates
What do credit ratings do?
measure the risk of default
If a company called Advanced Technologies has yet to pay a dividend on its stock, the generalized dividend model predicts that the company's stock may still have value because
people expect Advanced Technologies to pay dividends in the future.
what is efficient market hypothesis or the theory of efficient capital markets
people with better forecasts of the future get rich
According to the Generalized Dividend Model, the final sales price of a stock depends on the following except the
price of the stock in the last period.
What are bubbles?
prices of asset rise well above their fundamental values
what is default risk?
probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
what is the risk structure of interest rates?
relationship among interest rates in conjunction to risk, liquidity, and income tax
What is the term structure of interest rates?
relationship of bonds with different maturity rates
According to the Gordon Growth Model, the price of stocks depend on the following except
return on Treasure bills
If short term interest rates are lower in the beginning will they be expected to fall or rise?
rise
what happens when the yield curve is flat?
short- and long-term rates are the same
If bond investors decide that 30-year bonds are no longer as desirable an investment, the yield curve would:
steepen at the end of the yield curve and flatten somewhere along the rest of the curve
What are adaptive expectations?
suggests that changes in expectations will occur slowly over time as data for a variable evolve
The spread between the interest rate on a one-year U.S. Treasury bond and a 20-year U.S. Treasury bond is known as the
term premium
What are optimal forecasts?
the "best guess"
What is the generalized dividend model?
the generalized dividend model states that the price of a stock is determined only by the present value of the dividends and nothing else matters
What is the main downfall of the new credit rating system?
the new system inflates bond ratings
Suppose that you can buy a 1-year bond with i=5%. Alternatively, you can buy a 2-year bond that has i=7%. Which bond is better if you have $1,000 to invest? You expect that the interest rate between Year 1 and Year 2 is 9%.
the same 7+7=14 5+9=14
If the risk premium on corporate bonds increases, then
the spread between the interest rate on corporate bonds and the interest rate on default-free bonds has become greater.
What is risk premium?
the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds
Suppose that you can buy a 1-year deposit with i=5%. Alternatively, you can buy a 1-year zero-coupon bond with face value $1,050 which costs $1,000 right now. Which asset is better if you have $1,000 to invest? The bond or the deposit?
they are the same
A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise its risk premium
true
A decreasedecrease in the tax rate causes an increase in the interest rate on tax exempt bonds, such as municipal bonds.
true
A stocks prices will respond to announcements only when the information being announced is new and unexpected
true
Financiers and Accountants think differently! We are interested in economic cash flows not income. Example: When financiers buy a machine, they see one big expense spike up-front, followed by years of no further expenses. For this machine, accountants see depreciation: a little bit of use every year for many years. If you want to have an intelligent conversation about finance and economics, you must understand the language of accounting. In particular, you must understand what earnings are - and what they are not!
true
Finding undervalued securities is a hard task
true
If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well
true
In the market equilibrium, market price = fundamental price
true
The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time
true
Uncovering mispriced securities brings us closer to efficient markets
true
current prices in a financial market will be set so that the optimal forecast of a securities return using all available information equals the securities equilibrium return
true
What taxes are local or municipal bonds exempt from?
usually exempt from federal taxes
What taxes are exempt from US govt bonds?
usually exempt from local taxes
"According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond, if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?
False: These investments are almost of the same profitability.
