Chapter 4 Flashcards

Question

What is a financial instrument? KEY TERM

Answer 1

A financial instrument is a general term used to describe any form of funding medium. The term is most often used when describing short term money market financing mediums but can be equally used when describing longer term instruments such as shares and bonds

Answer 2

Cash instruments (e.g. shares and bonds) - the value is determined directly by the market

Answer 3

Derivative instruments (e.g. options futures etc) which get their name because their value derives from some underlying asset. (A good example of a derivative instrument is a share option which is valued partly based on what the price of the share that it relates to is doing.)

Answer 4

-Credit agreements -Mortgages -Bills of Exchange -Certificates of Deposit -Equities -Bonds -Mezzanine Finance -Venture capital -Impact of the company: Gearing

Answer 5

A generic arrangement whereby a party can obtain goods or services now but make repayments over a period of time (effectively borrowing to make the initial purchase). There are various types of format to a credit agreement such as credit cards, loans/overdrafts, HP/leasing, supplier credit terms

Answer 6

A mortgage is a loan that is generally secured over property such that if repayments are not made the mortgagor (e.g. the bank) has a right to take control of the property (repossession) from the mortgagee (e.g. you!)

Answer 7

These are commonly used in commercial business trading, particularly when making sales to a customer in another country. -In general, the lender (supplier) draws up the bill for a specified amount and repayment date (typically 90 days), the borrower (customer) signs the bill as acceptance of the terms. -There is an active market for trading these bills so that if the lender does not want to wait 90 days for the money they sell it on the secondary market for an amount slightly less than the face value of the bill

Answer 8

-A Certificate of Deposit (CD) is a time deposit. -It is similar to a saving accounts in that it is insured and virtually risk-free. -It is different from a savings account in that the CD has a specific, fixed term (often three months, six months, or one to five years), and, usually, a fixed interest rate. -It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest. -Some CDs are issued in a “negotiable” form which means they can be actively traded (bought and sold in the secondary market) at any point up until the maturity date.

Answer 9

Simple interest and compound interest

Answer 10

Simple interest refers to the interest earned on the amount of the original investment only, so that an equal amount of interest is earned each year

Answer 11

Compound interest refers to the idea that interest is calculated and paid on the original amount invested plus any accrued interest earned and received up to that point. This will mean that the interest earned each year will increase. This is more common than simple interest in all but the moststraightforward of loans.

Answer 12

S = X [1+r]^n X = initial investment (present value) S = investments value at the end of n periods n = number of periods investment is held for r = interest rate as decimal

Answer 13

Unless you are told otherwise, assume that any interest rates you are given in the exam are compound interest rates. Just be careful of the wording of the question. If the amount of capital increases or decreases due to additions or withdrawals, you should break the calculation down into segments for each addition/withdrawal In the equation 𝑆 = 𝑋 [1 + 𝑟]𝑛, it should be noted that ‘𝑛’ is the number of periods the investment is held for. This ‘period’ may or may not be a year

Answer 14

Annual percentage rate

Answer 15

The APR is the effective annual rate of interest for a given monthly or quarterly rate

Answer 16

R = (1+r)^n - 1 (1+R) = (1+r)^n R= APR r=interest rate for the period n=number of periods in a year Monthly, n = 12 Quarterly n = 4 Six monthly n = 2

Answer 17

a ‘nominal rate’ rather than an effective rate. For example, a credit card with a 2% monthly nominal interest rate could be quoted as having a 24% annual rate. Similarly, a card with an annual nominal rate of 12% could be quoted as having a 1% nominal monthly rate.

Answer 18

Some investments generate a constant return (i.e. the same amount received each period for a number of periods)

Answer 19

PV = S x (1-(1+r)^-n)/r

Answer 20

A business will often find itself needing to make a decision today based on estimates of future cash flows and so it will become necessary to work out what the value today is (present value) of all the future cash flows (future values). This can be done by rearranging the above formula to becom

Answer 21

X = S x [1 + r]^-n X= Prevent value S = Future value (1 + r)^-n = DISCOUNT FACTOR Present value = future value * discount factor

Answer 22

(1+r)^-n In the CBE exam there is a tables and formulae button, and if you click on it, you will see the discount factors for individual cash flows for whole percentages from 1% to 20% for periods 1 to 20 meaning you do not need to do this calculation, it is provided so you understand it. In the CBE exam the questions will usually ask for your answer to be to the nearest $10 or $100 because often these questions can be worked out two or three different ways with slight potential rounding consequences. You can be assured that the exam questions have considered rounding issues and that is factored into the wording.

Answer 23

PV = S x (1-(1+r)^-n)/r S=annual or periodic amount rest = annuity factor PV = annual (or periodic) cash flow * annuity factor ***Annuity factor is provided

Answer 24

An annuity that lasts forever

Answer 25

PV = S * (1/r) S=annual/periodic cash flow r= the interest rate/cost of capital Perpetuities can be advanced or delayed in the same way as annuities and you must be prepared to do those calculations too. Watch the wording in the question to see the relevant time periods

Answer 26

-Most investments will involve a series of cash outflows and inflows at different points in time. -If we calculate the present value of each cash flow and then add all the present values together, we can calculate the Net Present Value (NPV) of the investment. -This represents the PV of all the future inflows minus the PV of the outflows With NPV, it is assumed that all cash flows occur on the last day of the year/period except for the initial investment

Answer 27

Investments with a positive NPV (PV inflows > PV outflows) should be undertaken and those with a negative NPV should not.

Answer 28

The discount rate used will be the cost of capital (i.e. the retunr required by the investors)

Answer 29

The discount factor which gives a zero NPV -In simple terms the IRR tells us the actual % return that the project generates For a typical project that involves an initial outflow of cash followed by series of inflows, as the discount factor increases the NPV reduces (i.e. the project becomes less attractive as the cost of financing increases).

Answer 30

1) It allows for the time value of money 2) It does not require an exact cost of funds to be known. 3) As a % measure it is familiar to non-accountants 4) It looks at the entire project

Answer 31

1) It doesn't tell you whether to accept or reject the proposal 2) It is possible to have more than one IRR

Answer 32

If IRR > cost of capital -> accept project If IRR < cost of captial -> reject project

Answer 33

Step 1: Find the NPV of project using the discount rate given in the question (or use an estimate if none given in the question). Step 2: Find the NPV of project using a second discount rate. A general rule to follow here is that if your NPV in step 1 is positive then you should use a higher discount rate in step 2 (and vice versa for a negative answer in step 1). Step 3: Use the IRR formula below to estimate the IRR IRR ~~ L + (NPVL/(NPVL-NPVH))(H-L) Answer = n%

Answer 34

A yield refers to a return to the investor When placing a value on an investment both the return generated and the risks will need to be taken into account. There are a number of different yield measures that may be calculated

Answer 35

1) Running yield 2) Coupon rate (bill rate/nominal yield) 3) Gross redemption yield (yield to maturity) 4) Dividend yield

Answer 36

Running yield = Annual interest/Market Price This is sometimes called the interest yield

Answer 37

Dividend yield = Annual dividend/Market price(or share price) The dividend yield is similar to the running yield but in relation to shares (equity) rather than bonds. It indicates the current % dividend return in relation to the existing share price.

Answer 38

This is simply the interest rate offered on a bond and is the % of the nominal (par) value of the bond that is paid as interest each period.

Answer 39

This represents what the overall average return to the investor (bond holder) which takes into account both the interest returns and any capital gain or loss on redemption of the bond. Calculations of gross redemption yields are not required on the BA1 syllabu

Answer 40

TSR - total shareholder return

Answer 41

This is calculated as the dividend in the year plus the change in share price ALL divided by the share price at the start of the year. This will be expressed as a %.

Answer 42

RISK The higher the perceived risk in any investment the higher the required return will be

Answer 43

1- Low - Treasury bills (s/t govt securities) 2- Government bonds (longer term) 3 - corporate bonds 4- equities Short term gov issues treasury bills are considered to have negligible or zero risk, as there is little risk of the gov defaulting on its short term sterling borrowings

Answer 44

-Dividends may not be paid ( directors determine this) -You may not be able to sell the shares

Answer 45

The yield curve is a graphical representation of the relationship between interest rates on financial securities (e.g. bonds) and the term to maturity (i.e. how long it is until the underlying debt matures). The yield curve will normally ve represented as an upward sloping line The actual shape of the yield curve at any particular point in time will depend on the interaction of a number of different forces as well as the above factors. These include market expectations as to what interest rates might do over the short, medium and long term and supply and demand for borrowing for different lengths of time.

Answer 46

1) Liquidity Preference 2) Additional risk 3) Uncertainty on inflation

Answer 47

If an investor is tying their cash up for a longer period of time, then they will need to be compensated for this lack of liquidity. This is referred to as liquidity preference

Answer 48

The investor will need to be compensated for the additional risk of investing longer term in that there will be a greater degree of uncertainty surrounding the future performance of the economy/companies over a longer period

Answer 49

(Also, the uncertainty about what inflation will do over a longer period (and hence what future interest rates might do) creates greater risk for the longer-term investor). We will consider such factors in the later chapters

Answer 50

how long it is until the underlying debt matures

Answer 51

Real interest rate - the rate of return after inflation, as the return or yield of an investment is eroded away by inflation Nominal rate = the rate before adjusting for inflation, also referred to as 'money rate' sometimes

Answer 52

1 + RIR = (1+money rate)/(1+inflation rate)

Answer 53

A central bank sets the short term interest rates. -which can have a direct impact on the yields on other financial securities (e.g. shares and bonds) e.g. in the UK this is achieved by open market operations - the central bank buys and sells short term instruments (t-bills and s.t bonds) in the primary markets Also quantitative easing - see other card

Answer 54

By purchasing assests of the government (e.g. government bonds) or private sector (e.g. pension funds). -This can reduce interest rates via pushing up asset prices and lowering yields such that spending is encouraged again. - This is referred to as quantitative easing

Answer 55

-This type of debt finance is used in higher risk lending situations. -The debt is usually unsecured and carries a higher interest rate than normal secured bank borrowings. -There may well be equity warrants attached to the debt that allow the holder to purchase some equity shares in the company at a fixed price at some later date

Answer 56

Venture capital usually refers to equity financing for higher risk investment scenarios

Answer 57

A company that uses a large proportion of debt finance relative to equity finance is sometimes referred to as highly geared.

Answer 58

Equities refer to finance that is raised through the issue of shares. Two types of shares = ordinary shares and preference shares

Answer 59

Ordinary shares, holders of which are the owners of the business. Ordinary equity shares by nature are irredeemable (cannot usually be sold back to the company). They can be traded, ie sold on, to a third party. This is the most common type of share.

Answer 60

A preference share may contain some characteristics of both debt and equity. It is less likely to give the owner a right to vote in shareholder meetings than an ordinary share. EG1 Cumulative: if a dividend is not paid one year then it will be added on to dividends paid in later years EG2 Redeemable: may have rights to be bought back at a later date EG3 Participating: thave a right to a share in any excess profits over and above a certain amount

Answer 61

-A bond is a long-term debt instrument issued by a government or companies. -The term 'bond' relates to the fact that there is a written legal agreement with stated terms and conditions. -Most bonds are redeemable (i.e. they have a fixed repayment date) although a few irredeemable bonds do exist. Irredeemable bonds such as the 3.5% War Loan pay a fixed interest every year in perpetuity. -Bonds are sometimes called debentures (secured bonds) or loan stock (unsecured bonds), although most corporate (company) bonds in the UK are debentures.

Answer 62

-UK issued bonds will pay the owner interest based on the bonds “coupon rate” every 6 months. -Bonds that are issued in the UK but not denominated in £ and bonds that are issued in £ but not in the UK are examples of Eurobonds. Eurobonds pay interest annually. Coupon rates are also called ‘bill rates -Government bonds in the UK are referred to as GILTS (Government Index Linked Treasury Stock)

Answer 63

Corporate bonds are generally considered to be a slightly higher risk investment than government bonds and so will tend to offer a better yield to the investor

Answer 64

There are many different varieties of bond (e.g. zero-coupon, index linked, convertible…) but it is more important that you understand in principle what a bond is than being able to describe lots of different types. Refer to your text book if you are curious. Commercial papers were defined above as a source of finance. These can also be traded in the market (this is referred to be as being negotiable).

Answer 65

-By balancing or matching their payments and receipts -Refered to as 'syncronisation between payments and receipts'

Answer 66

-When there is not a balance between payments and receipts -Lack of synchronisation between payments and reciepts can happen in the short, medium or long term. -Financial intermediates take money from lenders and relend to borrowers to balance the lack of synchroisation -movement between these bodies in the economic system = flow of funds

Answer 67

It is assumed that the first payment/receipt takes place in one year or periods time -This is not the case if it is an advanced or delayed annuity perpetuity

Answer 68

The first payment/receipt will be taking place now (T0) -You simply have to add a years amount which has not been discounted to your normal annuity calculation - you don't have to account for the time value of money received now -Could also simply adjust the annuity factor by adding 1 to take account of the first cash flow happeneing at time 0 PV = Annuity x AF + annuity or Annuity x (AF +1) be careful for 10 years starting now - = 9 years + advanced

Answer 69

-The first payment/receipt would not be happening until some point after time 1. PV = Annuity * AF(6)*DF(2) or PV - Annuity * (AF(1-8)-AF(1-2))

Answer 70

The terminal value is the final, end value of the amount Terminal value - annuity * ((1+r)^n -1)/r

Chapter 4 Flashcards

(95 cards)