E1 P2- Lectures 2-4

Question 1

What is the foundation of any investment transaction?

Answer 1

sacrifice of present cash flow for a future cash flow

Question 2

When an investment is made compenstion must be made because of 3 things. What are they ?

Answer 2

1. Level of impatience - waiting for your cash
2. Risk - uncertainty of income
3. Inflation - purchasing power of money may drop

Question 3

What does a dollar today > a dollar tomorrow mean?

Answer 3

Money has a time-value, having it today is more valuable as you could invest it and earn an interest.

Question 4

What does interest rate tell you?

Answer 4

How high the rewards are / how costly borrowing is

Question 5

What is FV?

Answer 5

Future Value - it is the amount an investment will grow at the end of a period after gaining interest

Question 6

What is PV?

Answer 6

Present Value - the value today of a future cashflow

Question 7

What is discount rate?

Answer 7

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.

Question 8

Exam tip: what is helpful when working out PV and using discount rates?

Answer 8

Put on timeline

Question 9

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?

Answer 9

The higher the discount rate, the lower the PV

Question 10

What is a perpetuity?

Answer 10

A constant stream of identical cash flows that lasts forever.

Question 11

Give 3 examples of perpetuities

Answer 11

1. Real estate
2. Consols (perpetual bonds)
3. Shares (Gordon growth model)

Question 12

What is the difference between an annuity and a perpetuity?

Answer 12

A perpetuity has no termination date

Question 13

What is a growing perpetuity?

Answer 13

A stream of cash flows that grow at a constant rate forever?

Question 14

What is an annuity?

Answer 14

A stream of constant cash flows that last for a fixed number of periods

Question 15

When is an annuity ordinary?

Answer 15

When cash flows occur at the end of each period

Question 16

Give 3 examples of an ordinary annuity

Answer 16

Equities, bonds, regular loans

Question 17

What is it called when an cash flows occur at the beginning of a period?

Answer 17

It is an Annuity due

Question 18

Give 3 examples of annuities due. Why is this the case?

Answer 18

rent, phone bills, insurance coverage

remember it is like paying for a service, you must pay first to use

Question 19

Whenever you are working out the PV of a perpetuity, what must you do on a timeline?

Answer 19

Discount it until you are back to year 0

Question 20

How do you do derive annuities from perpetuities?

Answer 20

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)

Question 21

Define a coupon and coupon rate

Answer 21

Coupon - periodic interest paid on a bond
Coupon rate - the interest rate expressed as a % of the face value and paid until maturity

Question 22

What market do bonds operate in?

Answer 22

Bought and sold in the secondary market

Question 23

What is the face/par/principle value of a bond?

Answer 23

Is the principal payment at the maturity of a bond

Question 24

Define a bond

Answer 24

Debt security that gives the owner an enforceable right to certain future payments (coupon payments).

Question 25

Name the 6 types of bonds.

Answer 25

1. Plain vanilla / single-dated / straight 2. Zeros 3. Strips 4. Index-linked 5. Consol / undated / perpetual 6. Floaters / floating rate

Question 26

What is a Plain vanilla / single-dated / straight bond?

Answer 26

exact amounts and timing of all payments are set at the time of issue

Question 27

What are zero-coupon / Zeros bonds?

Answer 27

investors achieve their whole return at maturity with no interest payments. Their profit is their interest | self-explanatory

Question 28

What are Consol / undated / perpetual bonds?

Answer 28

issuer has the right (but not obligation) to repay the bond at any time but may continue to pay C (in perpetuity) forever instead

Question 29

What are strips?

Answer 29

the separate sale of coupon payments stripped from a C bond

Question 30

What are index-linked bonds?

Answer 30

Bonds that adjust their interest rate and V in line with inflation

Question 31

What are floaters?

Answer 31

bonds where the coupon rate is not fixed but is reset periodically

Question 32

What do you call sterling-denominated UK gov bonds?

Answer 32

gilts

Question 33

How are gilts divided?

Answer 33

by "maturity to redemption" into long, medium, short, ultra-short and undated

Question 34

Who issues bonds?

Answer 34

Central gov, local gov and municipalities as well as companies and supranational institutions

Question 35

What is a benefit of the Debt management office (DMO) publishing all info?

Answer 35

Transparency can help reduce interest the treasury is charged for borrowing money

Question 36

Describe the allocation of bonds in the UK market?

Answer 36

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

Question 37

Describe conventional gilts.

Answer 37

Single-dated bonds that pay interest semi-annually

Question 38

If an index-linked gilt is named 1.5% Treasury Gilt '24, what is the coupon rate and what is the year of maturity ?

Answer 38

1.5% c and 2024

Question 39

How do insurance companies with long-term liabilities effectively purchase and sell gilts?

Answer 39

They buy gilts with the same maturity as their commitments so they are certain they can pay them off

Question 40

Why do banks and building societies purchase gilts?

Answer 40

They keep investment in gilts because they are considered liquid assets.

Question 41

Why are gilts considered liquid?

Answer 41

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

Question 42

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?

Answer 42

When c = r

Question 43

what are the two measures of debt securities?

Answer 43

interest yield and redemption yield

Question 44

Describe interest yield as a measurement of bonds | 4 things

Answer 44

It divides Coupon by clean price does not consider time value of money ignores capital loss/ gains ignores accrued interest

Question 45

What is the redemption yield (APR) also known as?

Answer 45

Yield to maturity (YTM) and internal rate of return (IRR)

Question 46

Describe redemption yield (APR) as a measurement of bonds | 3 things

Answer 46

- 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

Question 47

Describe premium bonds

Answer 47

A bond with a current price > par value. Ie it trades for above £100 | as par value is £100

Question 48

Describe discount bonds

Answer 48

A bond with a current price < par value. ie trades for below £100

Question 49

What happens if you hold a discount bond until redemption?

Answer 49

capital gains

Question 50

What happens if you hold a premium bond until redemption?

Answer 50

It converges to V making you susceptible to capital losses

Question 51

What does it mean for a bond if the coupon rate is = to the discount rate?

Answer 51

price = £100

Question 52

What is the difference between coupons and dividends? | 3 things

Answer 52

Bonds vs Stocks Usually fixed vs variable on company performance Obligated vs usually not (can reinvest in to company)

Question 53

Like bonds stocks have 2 cash flows, what are they?

Answer 53

Dividends and sell price when stock is sold | sell price dependent on future dividends

Question 54

What model do you use when a stock has no dividend growth?

Answer 54

zero growth model

Question 55

What does the Dividend discount model predict?

Answer 55

- the value of an ordinary share equals the PV of all expected future payments

Question 56

What does the return on a stock equation split into?

Answer 56

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 =

Question 57

Do dividends reflect profitability?

Answer 57

No, they reflect a company's dividend policy, NOT its profitability

Question 58

What are the limitations of Gordon's growth model? | 4 things

Answer 58

- 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

Question 59

What is the solution to the limitations of the GGM?

Answer 59

Earnings Per Share (EPS) - look at earnings rather than dividends

Question 60

What is EPS made of?

Answer 60

a company's profit divided by the outstanding shares of its common stock.

Question 61

Why might stock price rise after a company temporarily reduces D?

Answer 61

- may be reinvested into the company, promising higher future D

Question 62

Define spot rates

Answer 62

- rates / prices quoted for an investment right now (on the spot) - they determine the price of a bond

Question 63

Define forward interest rate

Answer 63

an interest rate applicable to an investment that will take place in the future