Chapter 3: Arbitrage & Financial Decision-Making Flashcards
1
Q
how does management determine if an investment is good for the company
A
- When the benefits > costs, the decision made will increase the value of the firm = increasing the wealth of the investors
- The costs and benefits need to be compared in common terms to be compared
2
Q
what is the valuation principle
A
The value of an asset to the firm or its investors is determined by its competitive market price & the benefits and costs of a decision should be evaluated using these prices, and when benefits > costs, the decision will increase the market value of the firm
3
Q
what is net present value (NPV)
A
A way to compare the costs and benefits of a project in terms of a common unit; dollars today
4
Q
how can you use npv to determine if an investing decision is good for the company or not
A
- Then can determine if a decision is good or not based on determining if the today cash value of the benefits > the today cash value of the costs
- NPV is the net amount the decision will increase wealth
5
Q
what can you also use npv to determine the prices of
A
to determine the prices of securities that trade in the market
6
Q
what is arbitrage
A
A strategy that allows us to exploit situations in which the prices of publicly available investment opportunities don’t conform to these values
7
Q
what is a financial manager’s job
A
- to make decisions on behalf of the firm’s investors
- Ex. there’s an increase in demand for the company’s products
- Does the manager raise prices or increase production?
- If they need a new facility to increase production, do they rent or purchase it?
- If they purchase the facility, do they pay it in cash or borrow the money?
- How are decisions made to increase the value of the firm to the investors?
- Obviously when benefits > costs, but its usually hard to actually quantify that
8
Q
what skills of other management areas are needed to determine the costs and benefits
A
- marketing
- economics
- organizational behaviour
- strategy
- operations
These disciplines^ quantify the costs and benefits of the decision and the financial manager compares them to determine what to do to maximize the value of the firm
9
Q
how does marketing help determine the costs and benefits
A
Determine the increase in revenues from an advertising campaign
10
Q
how does economics help determine the costs and benefits
A
Determine the increase in demand from decreasing the price of a product
11
Q
how does organizational behaviour help determine the costs and benefits
A
Determine the productivity impact of a change in management structure
12
Q
how does strategy help determine the costs and benefits
A
Determine a competitor’s response to a price increase
13
Q
how does operations help determine the costs and benefits
A
Determine production costs after the modernization of a manufacturing plant
14
Q
what are the steps in decision making
A
- Identify the costs and benefits of a decision
- Quantify the costs and benefits
(costs and benefits can only be compared if they are in the same terms, like cash today)
15
Q
what is not considered when determining if a decision should be made and why
A
- the preferences of the individual
- because they can take whichever option has more value and sell it to get more value (and buy the other option if they want)
- Ex. you don’t want gold/think the current price of it is too high, but you choose to get gold, you can sell it since gold is the higher value compared to the silver
- Ex. you really need gold/thinks the current price is too low, if its too low, you can just buy it at that price
16
Q
what is a competitive market
A
A market in which goods can be bought and sold at the same price
17
Q
why can’t you use one-sided prices to determine an exact cash value
A
- One-sided prices determine the maximum value of the good (since it can always be bought at that price)
- But an individual may value it less based on their preferences for the good
17
Q
how is the price of a good determined
A
- The price of a good in the competitive market determines the cash value of the good
- As long as the competitive market exists, the value of the good won’t depend on the views or preferences of the decision maker
- By evaluating the costs and benefits using competitive market prices, can determine if a decision will make the firm and investors wealthier
18
Q
what happens when you don’t have competitive market prices
A
- you can’t make these decisions when you don’t have these prices
- Ex. prices in retail stores
- You can buy the stuff at the prices they are sold for, but you can’t sell them to the store for the same price (one-sided)
19
Q
what is the time value of money
A
- The difference in value between money today and money in the future
- Generally, a dollar today is worth more than a dollar in one year
- This is because if you have money today, you can invest it
19
Q
how can you convert money today into money in the future
A
- Can convert money today into money in the future with no risk by putting it into a savings account
- Can also convert money in the future for money today by borrowing from the bank
20
Q
what does the risk-free interest rate depend on
A
supply and demand
20
Q
what is the risk-free interest rate
A
- rf
- The interest rate at which money can be borrowed or lent without risk over a given period
21
Q
what is the rate used to exchange money today to money in the future
A
- the current interest rate
- Can use it to convert a currency at one point of time to the same currency at another point in time (like exchange rates and their ability to convert currency)
- So an interest rate is like an exchange rate across time
21
what can the current interest rate tell us
- It tells us the market price today of money in the future
- Ex. current annual interest rate is 7%
- If you invest or borrow at this rate, can exchange $1.07 in one year for $1 today
22
what is the interest rate factor
Interest Rate Factor = (1 + rf)
- Can exchange (1 + rf) dollars in the future per dollar today and vice versa without risk
- Used for risk-free cash flows, defining the exchange rate across time and calculating “$ in one year per $ today”
23
what is supply and demand at the risk-free interest rate
supply of savings = demand for borrowing
23
what is the risk-free rate used to calculate
the costs and benefits at the same time period
23
what is the present value (PV)
When the value is expressed in terms of dollars today (can be cost or benefit)
24
what is the future value (FV)
When the value is expressed in terms of dollars in the future
25
what is the PV formula
PV = FV / (1 + r)
- Since the pv of $1 in one year is less than $1, the price reflects a discount
- So this pv formula is called the one year discount factor
26
what is the discount rate
The risk-free interest rate
26
what does npv need to be in order to proceed with a decision
When NPV > 0, the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money
27
what is NPV when being used for making decisions
- The difference between the present value of its benefits and present value of its costs
NPV = PV (Benefits) - PV (Costs)
- NPV = the value of the project in terms of cash today
27
if +PV = benefits & -PV = costs, what is NPV
NPV = sum of present values
27
what is the NPV decision rule
- When making an investment decision, take the alternative with the highest NPV; its will be like receiving the NPV of this alternative in cash today
- When NPV > 0, the project is good because it will make the investor wealthier
- When NPV > 0, costs > benefits, so accepting it is like losing money today
27
what does corporations usually measures the values of the costs and benefits in
PV
28
what is NPV if you reject a project
- NPV = 0
- When you don’t do a project, you won’t get any new costs or benefits
29
what does NPV decision rule imply
that we should:
- Accept projects with +NPV because accepting them is equivalent to receiving their NPV in cash today
- Reject projects with -NPV because accepting them would reduce the wealth of investors, and not doing them will have no cost
29
how can you use the NPV decision rule to choose among projects
- You would choose the one that has the highest NPV
- Highest NPV = the one that will increase the value of the firm the most
30
what happens if NPV = 0
- you won’t gain or lose by accepting or rejecting the project
- Its not a bad project because it doesn’t reduce firm value, but it doesn’t add value either
30
what is the Separation of the Individual’s Consumption Preferences from the Optimal Investment Decision
- Regardless of our consumption preferences, we should always maximize NPV first
- We can then borrow or lend to shift cash flows through time to march our most preferred consumption spending pattern through time
- since some might want cash now, while some might want cash later
31
what is the first separation principle
The Separation of the Individual’s Consumption Preferences from the Optimal Investment Decision
32
what is arbitrage
The practice of buying and selling equivalent goods in different markets to take advantage of a price difference
33
what is arbitrage opportunity
Any situation where you can make a profit without taking any risk or making an investment
34
what happens when there is an arbitrage opportunity
- Because arbitrage opportunity has +NPV, investors will want to take advantage of it (it will increase their wealth)
- But only those who found the opportunity first have the ability to reap the benefits from it, and after that, the prices will change, making the arbitrage opportunity disappear
- Because arbitrage opportunities quickly disappear, the normal state of affairs in markets should be that no arbitrage opportunities exist
35
what is a normal market
A competitive market where there are no arbitrage opportunities
36
what is the law of one price
- If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in all markets
- If there were arbitrage opportunities, they will disappear until the prices in both markets are the same; law of one price
37
because of the law of one price, which price do we use
Because of the law of one price, we can just use the competitive price to determine the cash value and calculate the NPV without checking if there are other possible prices of the costs and benefits
38
what is a financial security (security)
An investment opportunity that trades in a financial market
39
what does the law of one price say about the prices of investments
- The Law of One Price says that the prices of equivalent investment opportunities should be the same
- Can use this to value a security if we can find another equivalent investment with a known price
- When we are dealing with risk-free securities, its easy to find an exactly equivalent security
40
what is a bond
- A security sold by governments and corporations to raise money from investors today in exchange for the promised future payment
- Bonds are securities with no risk that the payment won’t be made
41
what is the law of one price based on
- the possibility of arbitrage
- If the bond had a different price than the investment, then there would be an arbitrage opportunity
42
what is the no-arbitrage price
When the price of a security equals the PV of cash flows paid by the security in a normal market
43
what is the arbitrage strategy when the bond is overpriced
When the bond is overpriced, the arbitrage strategy is selling the bond and investing some of the proceeds
44
what is a short sale
- Selling a security you don’t own
- In a short sell, the person who wants to sell the security but they don’t own it would borrow it from someone who already owns it
- The seller would then need to return the security to the original owner by buying it back or paying the owner the cash flows they would’ve received
44
what is the general process for pricing other securities in a normal market
- Identify the cash flows that will be paid by the security
- Determine the “do it yourself” cost of replacing those cash flows on your own; the PV of the security’s cash flows
45
when would an arbitrage opportunity exist
if the price of a security isnt = PV
46
how to calculate the no arbitrage price of a security
Price (security) = PV (All cash flows paid by the security)
47
what is the risk free interest rate in relation to bonds
Risk-free interest rate = % gain you earn from investing in the bond; the bond’s return
48
how do you calculate the risk-free interest rate
Return = (gain at the end of year / initial cost) - 1
- Gain at the end of year = cash received - cash paid
OR rf = (FV/PV) - 1
49
if there is no arbitrage, what is the risk free interest rate
the return from investing in a risk-free bond
50
if you had a bond with a higher return than the risk-free rate, what would investors do
investors would earn a profit by borrowing at the risk-free interest rate and investing in the bond
51
if you had a bond with a lower return than the risk-free rate, what would investors do
investors would sell the bond and invest the proceeds at the risk-free interest rate
52
what is the no arbitrage equivalent idea
that all risk-free investments should offer investors the same return
(bond is risk-free, so the return from an investment with a risk free rate and a bond should be the same)
53
what kind of investment decisions increase the wealth of the firm and it investors
+NPV
- where cost = price paid for security
- benefit = cash flows received from owning the security
54
what is the value of trading securities at no-arbitrage prices
NPV (buy security) = PV (all cash flows paid by the security) - Price (security)
= 0
in a normal market (where there is no arbitrage), cost = benefit, so NPV = 0
55
since NPV of trading a security in a normal market = 0, what does it mean if NPV > 0
- If it was positive, then buying the security is like receiving cash today; there would be an arbitrage opportunity
- Since arbitrage opportunities don’t exist in normal markets, NPV of all security trades must be 0
56
does trading securities in a normal market create value
- Trading securities in a normal market neither creates nor destroys value
- Value is created by real investment projects like developing new products, opening new stores, or creating more efficient production methods
57
if no value is created or destroyed when trading securities, why is it done
- Financial transactions are not done to get more value (money) but just to adjust the timing and risk of cash flows to best suit the needs of the firm or its investors
- Because of this, we can separate a firm’s investment decision from its financing choice
58
what is the second separation principle
The Separation of the Investment and Financing Decisions
59
what is the separation principle of The Separation of the Investment and Financing Decisions
- Security transactions in a normal market doesn’t create or destroy value on their own
- So the NPV of an investment decision can be evaluated separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering
60
what is a portfolio
Term used to describe a collection of securities
61
what is value additivity
- A relationship determined by the Law of One Price, in which the price of an asset that consists of other assets must equal the sum of the prices of the other assets
- Ex. Price (C) = Price (A + B) = Price (A) + Price (B)
- Because security C has cash flows equal to the sum of A & B, its value/price should be the sum of the values of A & B
Otherwise, an obvious arbitrage opportunity would exist
62
if the total price of 2 securities (together) were lower than the portfolio that contained those 2 securities, what would happen
- arbitrage opportunity would exist
- then you can make a profit if you bought A & B and sold C
- This arbitrage activity would quickly push prices until the price of security C = total price of A & B
63
how does value additivity relate to the value of a firm
- Cash flows of the firm = total cash flows of all projects and investments within the firm
- Based on value additivity, the price/value of the entire firm = the sum of values of all projects and investments within it
- So the NPV decision rule coincides with maximizing the value of the entire firm
64
what should managers do to maximize the value of the entire firm
- To maximize the value of the entire firm, managers should make decisions that maximize NPV
- NPV decision represents its contribution to the overall value of the firm
65
what is risk
- The chance that an outcome may be different from the expected outcome
- Risky cash flow can turn out better or worse than what was expected
66
what does most individuals think about in terms of risk
the personal cost of loading a dollar in bad times is greater than the benefit of an extra dollar in good times
67
what is risk aversion
- When investors prefer to have a safe income rather than a risky one of the same expected amount
- ex. between getting $1100 for sure or $1100 on average ($800-$1400), investors would get $1100 for sure, or they would pay less to than $1100 to get $1100 on average
- Its based on preference
- Different investors have different degrees of risk aversion
68
what happens to the current price compared to a risk free bond if investors are more risk averse
The more risk averse investors are, the lower the current price of the market index will be compared to a risk-free bond with the same expected payoff
69
why can't you use only the risk-free interest rate to calculate PV of a risky future cash flow
- Since investors care about risk, can’t use the risk-free interest rate to calculate the PV of a risky future cash flow
- When investing in a risky project, investors expect a return that compensates them for the risk
70
what is an expected return
An calculation of the average return of a security based on the payoff we expect to receive on average
71
what is the equation for calculating the expected return
Expected return of a risky investment = expected gain at end of year / initial cost
- if there actual return could be higher or lower than the expected return, find the weighted average of the 2 returns (higher & lower) to find the average expected return
72
what is a risk premium
- Represents the additional return that investors expect to earn to compensate them for the security’s risk
- the difference between the expected return of the risky return and the return of a risk-free investment
73
how do you calculate the price of a risky security
- use the rate = the risk-free interest rate + risk premium
- use that rate to calculate the PV of the expected cash flows
74
what is the risk premium of the market index determined by
- Risk premium of the market index is determined by investors’ preferences toward risk
- Can use risk premium of the market index to value other risky securities like how we used the risk-free interest rate to determine the no-arbitrage price of other risk-free securities
