FM W3

Question 1

what is the yield curve

Answer 1

the graphic representation of the relationship between the yield of bonds of the same credit quality but different maturity

Question 2

what is the pure expectations theory

Answer 2

the forward rates exclusively represents expected future rates

Question 3

what would happen if economic news leads market participants to expect interest rates to rise

Answer 3

Market participants would not want to buy long-term bonds because they expect a price decline. Speculators expecting rising rates would anticipate a decline in the
price of long-term bonds and therefore would want to sell any
long-term bonds they own. Borrowers wishing to acquire long-term funds be pulled toward
borrowing now.

Question 4

what does the pure expectations theory not take into account

Answer 4

The risks inherent in investing in bonds.

Question 5

what are the two risks that cause uncertainty about the return over some investment horizon

Answer 5

1. The uncertainty about the price of the bond at the end of the investment horizon.
2. The uncertainty about the rate at which the proceeds from a bond that
   matures during the investment horizon can be reinvested and is known as reinvestment risk.

Question 6

what is the liquidity premium theory

Answer 6

explains the relationship between the yield of an investment and and its liquidity.

Question 7

do investors require a higher or lower rate of return on assets that are less liquid

Answer 7

higher rate of return.

Question 8

what is the preferred habitat theory

Answer 8

investors have a preference for bonds of one maturity over another

Question 9

are investors likely to prefer short-term or long-term bonds

Answer 9

short-term

Question 10

what is the segmented market theory

Answer 10

bonds of different maturities are not substitutes at all. If investors generally prefer bonds with shorter maturities that have less
interest-rate risk, then this explains why yield curves usually slope upward.

Question 11

The theory of the term structure of interest rates must explain the following facts…

Answer 11

1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to
   have an upward slope; when short-term rates are high, yield curves are
   more likely to slope downward and be inverted.
3. Yield curves almost always slope upward.

Question 12

what are 2 effects going public has on the firm

Answer 12

1. Changes the firm’s ownership structure by increasing the number of owners.
2. Changes the firm’s capital structure by increasing the equity investment in the firm.

Question 13

IPO Process:

Answer 13

1. Developing a prospectus (contains detailed information and risks etc).
2. Pricing (price of shares).
3. Allocation of IPO shares.
4. Transaction costs.

Question 14

bid

Answer 14

buy order specifying a price

Question 15

offer

Answer 15

sell order specifying a price

Question 16

best bid

Answer 16

standing buy order that bids the highest price bid

Question 17

best offer

Answer 17

standing sell order that has the lowest price offer

Question 18

market orders

Answer 18

to buy or sell at the best price currently available in the
market.

Question 19

limit orders

Answer 19

designate a price threshold for the trade

Question 20

short selling

Answer 20

selling borrowed securities not owned at time of sale to be
purchased later and returned

Question 21

buying on margin

Answer 21

borrows to buy securities using them as collateral

Question 22

why are stocks risky

Answer 22

borrowing creates leverage, leverage creates risk. Shareholders are residual claimants.

Question 23

how are stocks valued

Answer 23

1. Chartists - look at past movements.
2. Behaviouralists - look at investor psychology.
3. fundamentalists - estimating using both current assets and on estimates of future profitability.

Question 24

current price equation

Answer 24

P0 = (D1 + P1) / (1 + re)