Final Flashcards
Money Markets
The market where short-term
securities are bought and sold.
Capital Market
The market where long-term
securities such as stocks and bonds are bought and sold
Primary Market
The market in which new issues
of securities are sold to the public
Secondary Market
The market in which
securities are traded after they have been
issued.
Secondary Market
The market in which
securities are traded after they have been issued
When you buy, which price do you use?
Offer price
When you sell, which price do you use?
Bid price
The single most important issue in the stock
valuation process is…
What a stock will do in
the future
Value of a stock depends upon…
Its future returns
from dividends and capital gains/losses
The price of any stock is equal to…
The present value of the expected future dividends it will pay.
Dividend Payout Ratio
The fraction of earnings paid as dividends each year
We cannot use the constant dividend
growth model to value a stock if…
The growth rate is not constant.
Prices are set in
competitive markets as…
The price set by the
buyer willing to pay the most for an item
In finance, the standard deviation of a return is also referred to as
its…
Volatility
Variance
Summatory of (Expected return minus mean of expected return)^2 times the probability
Empirical Distribution
When the probability distribution is plotted using
historical data
Excess Returns
• The difference between the average return for an
investment and the average return for T-Bills
Is there a positive relationship between
volatility and average returns for individual
stocks?
there is no precise
relationship between volatility and average
return for individual stocks.
Common Risk
– Risk that is perfectly correlated
Independent Risk
– Risk that is uncorrelated
Diversification
– The averaging out of independent risks in a
large portfolio
Independent Risks are due to…
firm-specific news
Common risks are due to
Market wide news
Firm-Specific Versus Systematic Risk
When many stocks are combined in a large
portfolio, the firm-specific risks for each stock
will average out and be diversified.
– The systematic risk, however, will affect all firms
and will not be diversified.
The risk premium for diversifiable risk is…
Zero, so investors are not compensated for holding firm specific risk.
To measure the systematic risk of a stock…
Determine how much of the variability of its return is due to systematic risk versus
unsystematic risk.
Efficient Portfolio
A portfolio that contains only systematic risk.There is no way to reduce the volatility of the portfolio without lowering its expected return.
Market Portfolio
An efficient portfolio that contains all shares and securities in the market
A security’s beta is related to
How sensitive its underlying revenues and cash flows are to general economic conditions.
Market risk premium
The market risk premium is the reward investors
expect to earn for holding a portfolio with a beta of 1.
Capital Asset Pricing Model (CAPM).
It is the most important method for estimating the cost of capital that is used in
practice.
Modern portfolio theory (MPT)
Is a theory on how risk-averse
investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
Portfolio Weights
The fraction of the total investment in the portfolio held in each individual investment in the portfolio.
To find the risk of a portfolio, one must
Know the degree to which the stocks’ returns move together
In a short sale…
You sell a stock that you do not own and then buy that stock back in the future.
A bond is…
A debt investment in which an investor loans money to an entity (typically corporate or government) which borrows the funds for a defined
period of time at a variable or fixed interest rate.
Which is the most important force in the bond market?
The behavior of interests
Interest rates and bond prices move…
in opposite directions
Bond ratings are…
Letter grades that designate investment
quality
What is the single biggest factor that influences
the direction of interest rates?
Inflation
Value of an Asset =
Present value of its expected future cash flows
using the investor’s required rate of return as the discount rate.
Price of a bond is a function of
Its coupon rate, its maturity, and market
movements in interest rates
YTM refers to …
the rate of return the investor will earn if the bond is held
to maturity. YTM is also known as bondholder’s expected rate of return.
Current Yield =
Annual interest payment/
current market price of the bond
Bond Duration:
A measure of bond price volatility, which captures both
price and reinvestment risk and which is used to indicate how a bond
will react in different interest rate environments
