E1 P2- Lectures 2-4 Flashcards
What is the foundation of any investment transaction?
sacrifice of present cash flow for a future cash flow
When an investment is made compenstion must be made because of 3 things. What are they ?
- Level of impatience - waiting for your cash
- Risk - uncertainty of income
- Inflation - purchasing power of money may drop
What does a dollar today > a dollar tomorrow mean?
Money has a time-value, having it today is more valuable as you could invest it and earn an interest.
What does interest rate tell you?
How high the rewards are / how costly borrowing is
What is FV?
Future Value - it is the amount an investment will grow at the end of a period after gaining interest
What is PV?
Present Value - the value today of a future cashflow
What is discount rate?
The interest rate used to discount cash flows received in future years. It is the opportunity cost of capital, given the risk of future cash flows.
Exam tip: what is helpful when working out PV and using discount rates?
Put on timeline
The longer you have to wait for your money the less it is worth today. What does this mean for discount rates and present value?
The higher the discount rate, the lower the PV
What is a perpetuity?
A constant stream of identical cash flows that lasts forever.
Give 3 examples of perpetuities
- Real estate
- Consols (perpetual bonds)
- Shares (Gordon growth model)
What is the difference between an annuity and a perpetuity?
A perpetuity has no termination date
What is a growing perpetuity?
A stream of cash flows that grow at a constant rate forever?
What is an annuity?
A stream of constant cash flows that last for a fixed number of periods
When is an annuity ordinary?
When cash flows occur at the end of each period
Give 3 examples of an ordinary annuity
Equities, bonds, regular loans
What is it called when an cash flows occur at the beginning of a period?
It is an Annuity due
Give 3 examples of annuities due. Why is this the case?
rent, phone bills, insurance coverage
remember it is like paying for a service, you must pay first to use
Whenever you are working out the PV of a perpetuity, what must you do on a timeline?
Discount it until you are back to year 0
How do you do derive annuities from perpetuities?
It is the difference between an annuity starting from year 1 and one from year 1 + t
equation wise it is the expanded PV of an annuity one - c/r (1 - 1/(1+r)
Define a coupon and coupon rate
Coupon - periodic interest paid on a bond
Coupon rate - the interest rate expressed as a % of the face value and paid until maturity
What market do bonds operate in?
Bought and sold in the secondary market
What is the face/par/principle value of a bond?
Is the principal payment at the maturity of a bond
Define a bond
Debt security that gives the owner an enforceable right to certain future payments (coupon payments).
Name the 6 types of bonds.
- Plain vanilla / single-dated / straight
- Zeros
- Strips
- Index-linked
- Consol / undated / perpetual
- Floaters / floating rate
What is a Plain vanilla / single-dated / straight bond?
exact amounts and timing of all payments are set at the time of issue
What are zero-coupon / Zeros bonds?
investors achieve their whole return at maturity with no interest payments. Their profit is their interest
self-explanatory
What are Consol / undated / perpetual bonds?
issuer has the right (but not obligation) to repay the bond at any time but may continue to pay C (in perpetuity) forever instead
What are strips?
the separate sale of coupon payments stripped from a C bond
What are index-linked bonds?
Bonds that adjust their interest rate and V in line with inflation
What are floaters?
bonds where the coupon rate is not fixed but is reset periodically
What do you call sterling-denominated UK gov bonds?
gilts
How are gilts divided?
by “maturity to redemption” into long, medium, short, ultra-short and undated
Who issues bonds?
Central gov, local gov and municipalities as well as companies and supranational institutions
What is a benefit of the Debt management office (DMO) publishing all info?
Transparency can help reduce interest the treasury is charged for borrowing money
Describe the allocation of bonds in the UK market?
First bonds are given out via competitive public auctions (primary market) to the GEMMs (gilt-edged market makers)
Then, bonds are traded on secondary markets
Describe conventional gilts.
Single-dated bonds that pay interest semi-annually
If an index-linked gilt is named 1.5% Treasury Gilt ‘24, what is the coupon rate and what is the year of maturity ?
1.5% c and 2024
How do insurance companies with long-term liabilities effectively purchase and sell gilts?
They buy gilts with the same maturity as their commitments so they are certain they can pay them off
Why do banks and building societies purchase gilts?
They keep investment in gilts because they are considered liquid assets.
Why are gilts considered liquid?
They are actively traded in financial markets and their underlying assets are usually cashflows of the government which are trusted
- therefore they are also less risky
Long-term bonds are more affected by interest rates than short-term bonds. When do two bonds that are the same but different lengths sell for the same face value?
When c = r
what are the two measures of debt securities?
interest yield and redemption yield
Describe interest yield as a measurement of bonds
4 things
It divides Coupon by clean price
does not consider time value of money
ignores capital loss/ gains
ignores accrued interest
What is the redemption yield (APR) also known as?
Yield to maturity (YTM) and internal rate of return (IRR)
Describe redemption yield (APR) as a measurement of bonds
3 things
- considers the time value of money
- assumes the bond is acquired on the coupon date and is held until maturity
- for bond with more than 1 year until maturity it is calculated using trial and error
Describe premium bonds
A bond with a current price > par value. Ie it trades for above £100
as par value is £100
Describe discount bonds
A bond with a current price < par value. ie trades for below £100
What happens if you hold a discount bond until redemption?
capital gains
What happens if you hold a premium bond until redemption?
It converges to V making you susceptible to capital losses
What does it mean for a bond if the coupon rate is = to the discount rate?
price = £100
What is the difference between coupons and dividends?
3 things
Bonds vs Stocks
Usually fixed vs variable on company performance
Obligated vs usually not (can reinvest in to company)
Like bonds stocks have 2 cash flows, what are they?
Dividends and sell price when stock is sold
sell price dependent on future dividends
What model do you use when a stock has no dividend growth?
zero growth model
What does the Dividend discount model predict?
- the value of an ordinary share equals the PV of all expected future payments
What does the return on a stock equation split into?
Dividend yield (%) D1 / P0*100
or
Capital gain yield (%) (P1 - P0) / P0*100
second can be positive (Capital gain) and negative (loss). it is also =
Do dividends reflect profitability?
No, they reflect a company’s dividend policy, NOT its profitability
What are the limitations of Gordon’s growth model?
4 things
- some companies may have no D history
- relies on the assumption the ‘normal’ growth rate, g is known and stable
- small changes in g and r greatly change P0
- does not consider nondividend company value like customer retention and brand loyalty
What is the solution to the limitations of the GGM?
Earnings Per Share (EPS) - look at earnings rather than dividends
What is EPS made of?
a company’s profit divided by the outstanding shares of its common stock.
Why might stock price rise after a company temporarily reduces D?
- may be reinvested into the company, promising higher future D
Define spot rates
- rates / prices quoted for an investment right now (on the spot)
- they determine the price of a bond
Define forward interest rate
an interest rate applicable to an investment that will take place in the future
