Exam 2 Flashcards
The graphic relation between YTM and term to maturity
The yield curve
Structure of interest rates
A downward sloping yield curve
Inverted curve
A blend of returns from the multiple coupons and principal received at various times
YTM on a coupon bond
A “pure” annualized return through the maturity date
YTM on a zero-coupon bond
The implied future one-year interest rate that makes the cumulative return from investing in a pair of Strips, the first bought now and maturing at T-1, and the second bought at T-1 and maturing at T, equal the cumulative return on a strip bought now and maturing at T
One-year forward rate
States that yields to maturity on long-term bonds are determined solely by market expectations of future short-term interest rates
Expectations Hypothesis
If investors expect economic growth to accelerate, then they will generally expect short-term rates to rise in the future
Expectations of economic growth
If investors expect inflation to rise in the future, then they will generally expect short-term rates to rise. To preserve the same pre-tax real interest rate, short-term rates must increase one-for-one inflation
Expectation of inflation
Postulates that investors demand a yield spread or premium for purchasing long-term bonds rather than short-term bonds, because short-term bonds are inherently more liquid
The liquidity preference theory
Three risks to think about when investing in Treasury securities:
Price risk, reinvestment risk, and inflation risk
The risk that the price of a bond will be low at a time you might want to sell it. There is none if you hold until maturity
Price Risk
The risk that market interest rates will be low when you want to reinvest the principal from a maturing bond, or reinvest bond coupons
Reinvestment risk
The risk that consumer prices will rise, reducing the purchasing power of the principal and coupons on your bond
Inflation risk
Stock represents ownership shares in a corporation, shareholders own a part of the company in which they have invested
Common stock
Oversees all operations of the company
Board of directors
Staggered election
Classified board
When a board member is a current or former company executive
Inside director
Sets the compensation of top executives
Outside directors
When there are two competing slates of candidates for the board of directors
Proxy fight
Payments of cash from the company to its shareholders
Cash dividends
Usually one business day before the record date
Ex-dividend date
As the ratio of dividends per share to earnings per share over the past 12 months
Payout ratio
Equal to the current annualized dividend as a percentage of the current stock price
Dividend yield
When a corporation buys its own stock
Share repurchase or buyback
Specifying a single price or range of prices they will pay for each share tendered
Tender off
the company is like any other buyer of stock in the market, so individual shareholders get cash only if they sell their shares in the market
Open market repurchases
Each share of stock will be split into more than one share
Stock split
When companies go public, they usually sell stock, and the stock sale is the ___
Initial Public Offering (IPO)
The price that is paid by public investors to the company for the new shares
Offering price
The SEC registration of securities (stocks and/or bonds) for an offering to be made on a continuous or delayed basis in the future
Shelf registration
The latest trade price for the stock
Last Trade
Highest price anyone is bidding to buy the stock from you
Bid Price
The lowest price anyone is asking to sell the stock to you
Ask Price
These figures indicate the range of the stock price over the past year, adjusted for stock splits if any
52-week high and low
The most recent cash dividend paid, usually expressed on an annualized basis
Dividend
The dividend yield, equal to the annual dividend as a percentage of the current stock price
Yield Percentage
Equal to the current stock price dividend by latest 12-month reported EPS
Price-to-earnings ratio
Current price divided by the consensus forecast of next year’s earnings per share
Forward P/E
Measures the total market value of all the stock outstanding, equal to share price times the number of shares outstanding
Market capitalization
The number of shares traded
Volume
Change in price from the previous day
Net change
Indexes measure how prices for stocks as a group (or on average) are behaving
Stock market indexes
Investors can earn from investing in stocks rather than investing in (safer) bonds
Risk Premium
The component of a stock’s risk that is related to the stock market as a whole
Market risk or systematic risk
Measures the general sensitivity of the return on a stock to the return on the overall stock market
Beta
A beta above 1
Cyclical stock
A beta below 1
Defensive stock
Dividing of investment funds among different securities
Diversification
Publicly traded companies that purchase and typically manage commercial real estate
Real Estate Investment Trusts (REITs)
Difference between bid and ask prices
Bid-ask spread
Number of shares available to buy or sell at that ask or bid price
Depth
Market orders are executed at a price better than the current quote
Price improvement
An order to buy or sell a particular number of shares at a certain price or better
Limit order
An order to sell at the market if the bid price reaches or falls below a particular price
Stop-loss order
Regular brokerage accounts
Cash accounts
You are allowed to borrow a part of your investment from your broker
Margin account
published daily in the Wall Street Journal, is the rate banks charge to brokers to borrow money, and is usually a couple percentage points above the interest rate on Treasury Bills
Call money rate
you first borrow shares from your broker, immediately sell them in the market, and then buy them back at a later date to return to your broker
Short selling
The number of a company’s shares that have been sold short
Short interest
Total shares outstanding minus shares held by corporate insiders
Float
Insider trading (legal and illegal)
The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.
Realized when you sell a stock for more (or less) than you originally paid for it
Capital gain (or loss)
The amount you originally pay for a stock
Cost basis
The higher the expectations for future economic growth and inflation, the more ____ will be the yield curve
Steeply sloped
Long-term bonds are inherently ____ than short-term bonds, and hence longer bonds have a positive liquidity ____ in their yields
Less liquid
Premium
Long-term bonds are more subject to the risk of higher ____ than short-term bonds, so long-term bonds have an inflation risk ____ in their yields
Inflation
Premium
Since most investors have relatively short time horizons, ___ risk is more important than ___ risk, so long-term bonds have a ___ risk premium in their yields
Price risk
Reinvestment risk
Price risk premium
Can be redeemed by the issuer prior to the bonds’ maturity date, in exchange for the call price
Callable bonds
The call price is ____ than or equal to the __ value, often starting at a ____% premium to par and then declining to par as maturity approaches
Greater than or equal to the par value
3-5% premium
Motivations for calling a bond (3):
- Reducing interest expenses going forward by refinancing
- Deploying excess cash
- Fear of higher market rates, extend maturity now!
Alternative to calling a bond:
Buy back your company’s bonds on the open market
Allows the issuer, at its option, to redeem the bonds. Issuers may exercise after a certain number of years, often ten years
Optional Redemption
Requires the issuer to regularly redeem a fixed portion or all of the bonds in accordance with a fixed schedule
Sinking Fund Redemption
These days, most callable bonds have ___ redemption, and do not have ___ redemption
Optional
Sinking fund
Period during the first few years of the bond’s life, where calls are prohibited
‘Lockout’ period
When a callable bond is trading at a premium to the call price, and is thus likely to be called, ____ may be misleading
YTM
Annualized rate of return from purchasing the bond and then holding it until the next likely call date, assuming no default and that the bond will actually be called
Yield to call
Yield to call calculation is the same as the YTM calculation, with the ____ date substituted for the ___ date, and the ____ substituted for the par value
call date substituted for the maturity date
Call price
At a specified date, the holder can choose to redeem the bond for par value, or alternatively choose to keep it, effectively extend the life of the bond for a given number of years
Puttable bonds
Allow the holder to convert their bond to common stock in a predetermined ratio
Convertible bonds
Predetermined ratio for convertible bonds is called the
Conversion ratio
Par value of the bond divided by the conversion ratio
Conversion Price
Conversion ratio times the market price per share of the common stock
Conversion Value
Difference between the market price of the convertible bond and the conversion value
Conversion Premium
When issued, the coupon rate on convertibles is set ______ for ‘straight’ bonds of the same credit rating
Below the market rate
When issued, the convertibility option is “_______” (the conversion value is less than par), so that immediate conversion would not make sense
“Out-of-the-money”
Many convertible bonds are ____
Callable
When a convertible is called at a time when the conversion value exceeds the call price, such a call is said to ____ conversion into stock
“Force”
In general, it is not logical to convert unless the ____ price in the market exceeds the ____ price, and even then, it usually makes sense to defer conversion for as long as possible
Stock price
Conversion price
If yields on long-term bonds ___ yields on short-term bonds, the yield curve is said to be upward sloping
Exceeds
If yields on long-term bonds are less than yields on short-term bonds, the yield curve is said to be ____ sloping
Downward
Expectations hypothesis states that yields to maturity on long-term bonds are determined solely by market expectations of …
Future short-term interest rates
Under the expectations hypothesis theory, if the yield curve slopes upward (downward), that means investors believe future short-term rates will be ____ than current short-term rates
Higher (lower)
In terms of forward rates, the expectations hypothesis states that the one year forward rate is always equal to ____ expected one year actual or ‘spot’ rate between T-1 and T.
The market’s
The slope of the yield curve is a _____ indicator
Leading economic
If investors expect inflation to rise in the future, then they will generally expect short-term rates to…
Rise along with it
Inflation:
To preserve the same pre-tax ___ interest rate, short-term ___ rates must increase one-for-one with inflation
Real
Nominal
The yield curve will have a ____ slope when investors believe the economy will improve and/or inflation will increase in the future
Steep upward
The yield curve will ___ when a recession, possibly combine with lower inflation, is predicted
Invert
If future economic growth and inflation are expected to be about the same as they are now, the yield curve will be ___
Flat
The liquidity preference theory postulates that investors demand a yield spread or premium for purchasing ____ bonds rather than ____ bonds, because ___ bonds are inherently less liquid
Long-term
Short-term
Long-term
In practice, long-term treasury bonds are _____ liquid, so it is not clear that any sizable “term” spread can be explained by liquidity differences alone
Highly
Relative risks of investing in short-term versus long-term bonds
- Price risk
- Reinvestment risk
- Inflation risk
Difference between investing in bonds versus bond mutual funds:
Bond mutual funds never mature!
Treasury bonds and notes have no _____
Risk of default
The dividends paid by treasury bonds and notes are taxable by the _____, but you get a break on your _____
Federal government
State income taxes
U.S. government agency funds like GNMA (Government National Mortgage Association) are _____
Mortgage-backed securities (MBS)
MBS bonds are very low ____ and are highly ___, though only GNMA securities are considered perfectly default-free like treasury bonds
Default-risk
Rated
MBS funds have ____ risk, because homeowners have the option to ___ their mortgage loans
Prepayment
Prepay
Junk bonds promise a ____ than government or corporate investment-grade bond, but with ____ risk
Higher return
Higher
If the country were to ever go into a deep recession or depression, ___ bonds could be expected to perform very poorly, right at the same time that stocks would be doing ___
Junk bonds
Poorly
Defaults have ____ significantly in past recessions
Risen
One indicator of the potential future return on bond fund investments is the _______ of the fund
Weighted-average yield to maturity
The yield to maturity on a bond is the _____ from holding a bond to maturity if the bond does not ____
Average annual return
Default
Do not invest in junk bond funds unless the YTM is ______ the yield on investment-grade corporate or treasury bond funds
Well above
Dividends paid by municipal bond funds are _____ by the federal government
Not taxable
What is the difference between national and single-state municipal bonds?
National municipal funds buy municipal bonds from all around the country while single state municipal funds invest in the municipal bonds of a specific state
For wealthy individuals living in a state with a high income tax rate, like New York or California, single state funds can be ___, because their dividends are exempt from ___ income tax and ___ income tax for ____
Attractive
Federal
State
Residents of that state
Invest in bonds issued by foreign companies and governments as well as domestic bonds
International bond funds
International bonds:
Expense ratios are often ___, and your investment is subject to ____
High
Currency risk
International bonds:
Purchasing these funds often amounts to a bet that the U.S. dollar will ____ against other currencies
Depreciate
Within many of these general fund categories, you can find funds that specialize by their maturity. For example, your can buy ___, ___, or ___, maturity U.S. Treasury Bond funds
Short, intermediate, or long maturity
Historical returns:
Look for a fund that earns returns above the average for its fund type over the past ____ years
5-10
Historical returns:
Compare returns on a short-term Treasury fund to ______, not to ______
Other short-term Treasury funds, not to corporate or municipal funds
Manager Tenure:
If a fund has a good long-term record from active bond investing, check to see if the _____ has changed. If the _____ is gone, past performance has no predictive value
Management team
“Star” manager
Default Risk:
U.S. Treasury funds are _____. Corporate and municipal bond funds have ____ default risks depending on their ____
Default-free
Varying
Credit quality
Investors that are very risk averse should generally avoid ___ bond funds
Junk
Interest Rate Risk:
Interest rate risk is higher for ____ bond funds than for ____ funds
Long-maturity
Short-maturity
If you have a short investment time horizon of only 2-3 years, you probably should avoid ____ funds
Long-maturity
The interest rate risk of bonds and bond funds is measured by ____
(Modified) Duration
The ____ the duration of the bond fun, the ____ the interest rate risk
Longer
Higher
Interest Rate Risk:
As an approximation, if the fund has an average modified duration of 7 years and interest rates in the market rise by 1%, say from 5% to 6%, the NAV of the fund will fall by about __%. If interest rates fall by __%, the NAV will rise by about 7%
7%
1%
Expense Ratio:
Look for a fund that has expenses below ___ of assets per year. The larger, more efficient funds are able to keep their expense that low
0.4%
Turnover:
Turnover refers to the fund’s _____
Trading frequency
Turnover:
A turnover rate of 20% indicates that ____ of the securities held at the beginning of the year are sold and traded for other securities during the year
one-fifth
A turnover of ___ indicates that the average security in the portfolio is held for one year
100%
All else equal, ___ turnover is undesirable, because it indicates that fund incurs high transaction costs and may frequently realize taxable short-term capital gains
High
_____ bonds funds will naturally have higher turnover than ____ funds, because their bonds mature _____
Short-term
Long-term
Much more frequently
High turnover (more than 100% per year) in a long-term bond fund is a sign that the manager is trying to ___ interest rate movements by ___ bonds
Time
Trading
A manager trying to time the market buys longer maturity bonds when they expected interest rates to __, and buyers shorter maturity binds when they expect rates to __
Fall
Rise
Dividends from corporate bond funds are subject to ______ income taxes
Federal, state, and local
U.S. Treasury Bond fund dividends are exempt from __ and __ income taxes for the portion of their earnings (usually well over 90%) that comes from Treasury Bonds
State and local
Federal municipal fund dividends are exempt from ____ income taxes, while individual state municipal fund dividends are exempt from __ and __ taxes
Federal
Federal and state (if you live in that state)
Historically, most bond mutual funds slightly ___ the overall bond market
Underperform
Choose a bond with no ____, low ____, and low ____. These funds usually generate the best ____
No sales loads
Low expenses
Low turnover
Long-term returns
Net cash flows into bond funds are ___ correlated with the change in bond yields over the past 12 months
Negatively
Low market interest rates imply ____ returns from bond fund investing!
Low FUTURE returns
Represents ownership shares in a corporation
Common stock
A few corporations sell shares directly to the public using _____
Direct stock purchase plans
Public corporations hold annual meetings, and prior to each annual meeting, common stockholders receive a ballot to vote on candidates for the corporate ____
Board of directors
Board with a staggered election, so that (for example) each director has a three-year term and 1/3 of directors come up for election each year
Classified board
When a board member is a current or former company executive, they are called ___
Inside director
The compensation committee, a committee of the board including only ___ directors, sets the compensation of top executives
Outside
Who decides on if a company will pay a dividend and what amount it would be?
The board
Except in unusual circumstances, directors run ___
Unopposed
If a company has _____, election requires a “for” vote majority, versus ____ or ____ votes
Majority
“Against” or “withheld”
With majority voting, a director must be replaced if ____ votes exceed ____ votes, with the new director selected by the nominating committee of existing directors
“Against” or “withheld” votes exceed “for”
With ____ voting, if a director runs unopposed, the director is elected with only a single __ vote, so the individual stockholder’s vote is basically meaningless
Plurality
“For” vote
When there are two competing slates of candidates for the board of directors, this is referred to as a ____
Proxy fight
The annual ballot sent to shareholders also contains various proposals made by ___ and/or ___
Managers and/or outside stockholders
Proposals by management include (3):
- Whether or not to accept a merger with another company (though this usually has a separate special vote)
- The adoption of stock option incentive plans for top managers
- Hiring a particular account firm to audit the company’s financial statements
Proposals by outside stockholders include (3):
- Limits on the pay or bonuses of executives
- Disclosure of political contributions
- Restrictions on doing business in countries that allegedly violate human rights
The proposals by outside shareholders are just ___ in most cases, not ____, but most CEOs do not want to be seen as totally disregarding the will of the shareholders
Advisory
Legally binding
Normally, each share of common stock carries ___ vote, but sometimes there are different ___ of common stock with different privileges or voting rights
One vote
Classes
Unlike the holder of a corporate bond, common stockholders are not entitled to _____
Receive any particular income payment from the company
If a company gets into financial difficulties and must liquidate (sell) their assets in a bankruptcy proceeding, ____, other _____, ____, and ____ have first claims on the money
Bondholders, other lenders and creditors, lawyers, and the IRS
Common stockholders have a __ or __ claim in bankruptcy which means common stockholders will be the _____ if the company must liquidate
Junior or residual
Last to be paid
On the plus side, common stockholders in a corporation have _____, they are not personally liable for the corporation’s debts, so can never lose more than their ___ in the stock
Limited liability
Original investment
Hybrid of common stock and a corporate bond
Preferred stock
Preferred stock normally pays ___ dividends, as a fixed percentage of the ____
In this sense, preferred stock is more like a ___ than a ____
Quarterly
Par value
Bond than a common stock
Failure to pay a scheduled dividend does not trigger _____, like would a failure to pay ___ or ___ on a bond
However, missed dividends often provide preferred stockholders collectively with a ______
Bankruptcy
Interest or principal
Certain number of seats on the board of directors
The dividend on preferred stock can be either ___ or ___
If the former, then all dividends payments that were missed must be made up before…
Cumulative or non-cumulative
Any dividends can be paid to common stockholders
Most preferred stock issued by banks is _____, which helps satisfy capital requirements with bank regulators
Non-cumulative
Most preferred stock is ____, like common stock. Many preferred stocks have a maturity or mandatory redemption date, like a bond. Many preferred stocks are ____ at their ___ value after a certain number of years
Perpetual
Callable at their par value
In the case of bankruptcy, preferred stock is ___ to common stock, but ___ to all liabilities
Senior to common stock but junior to all liabilities
Sometimes preferred stock is ____ into common shares
Convertible
Convertible preferred is often used in _____, where the company is not yet profitable and hence cannot take advantage of the tax-deductibility of convertible bond interest payments
Venture capital situations
A stock has real value only to the extent that the company can…
Distribute cash to stockholders at some point in the future
The ___ the present value of the expected cash flows paid from the company to stockholders, the ____ is the stock
Higher
More valuable is the stock
Cash distributions primarily take the form of ____, but can also come through ____. You can also receive cash if another company buys your stock for cash in a _____
Cash dividends
Share repurchases
Corporate takeover
Earnings can be… (4):
- Paid out to stockholders as dividends
- Used to pay off debt or repurchase stock
- Used to buy another company
- Reinvested into the business
Most dividends are so-called ____ dividends, paid on a regular basis, typically _____. Companies can also pay special ____ extra dividends if they choose
Regular
Quarterly
“One-time”
Dividends are always announced in the _____ prior to their ____
Financial press prior to their actual payment
Date that is usually one business day before the record date
Ex-dividend
Example:
A company announces on March 15th that it will pay a $0.30 dividend on April 20th, to shareholders of record at the close of business on Friday, April 1st, with an ex-dividend date of March 31st. What date is the deadline of owning a stock to get the dividend?
March 30th, the day before the ex-dividend date
If you buy a stock on the ex-dividend date of March 31st or later, you do not receive the dividend
Stock prices usually fall by approximately the ______ at the open of trading on the ex-dividend date, so there are no easy profits to be made by buying the stock the day before the ex-dividend date and selling it on the ex-dividend date
Amount of the dividend (or a little less)
