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Year 2, Sem 1 > Foundations of Finance 1 > Flashcards

Foundations of Finance 1 Flashcards

1
Q

to move a CF foward in time

A

we compound it to account for anticipated growth

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2
Q

future value formula

A

FV0 = C0(1+r)^n

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3
Q

to move a CF backward in time

A

we discount it to account for the fact we have to wait for it

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4
Q

present value formula

A

PV0 = Cn / (1+r)^n

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5
Q

if discount rate > 0

A

0 < DF < 1

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6
Q

if discount rate < 0

A

DF > 1

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7
Q

total present value formula

A

C0 + C1/(1+r) + C2/(1+r)^2 + C3/(1+r)^3

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8
Q

NPV formula

A

= PV(inflows) - PV(outflows)

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9
Q

if NPV > 0

A

accept project

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10
Q

perpetuity

A

stream of equal cash flows that occur at regular intervals and last forever

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11
Q

perpetuity formula

A

PV = C/r

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12
Q

growing perpetuity

A

stream of cash flows that occur at regular intervals which grows at a constant rate forever

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13
Q

growing perpetuity formula

A

PV = C / r-g

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14
Q

constant annuity

A

stream of N equal cash flows paid at regular intervals, number of payments is fixed, start at t=1

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15
Q

constant annuity PV and FV formulas

A

PV = C/r x [1 - 1/(1+r)^N],
FV = C/r x [(1+r)^N - 1]

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16
Q

growing annuity

A

fixed number of N growing cash flows paid at regular intervals

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17
Q

growing annuity formula

A

PV = (C / r-g) x [1 - (1+g / 1+r)^N]

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18
Q

things to include in any NPV/IRR calculation

A

any CFs that arise directly from project, any cash outflows in future directly from project, any forgone income which might otherwise have been earned, any future purchases which will be reduced as result of project, effect of project on existing projects

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19
Q

things to exclude from any NPV/IRR calculation

A

any sunk or fixed costs that are independent of investment decision and cannot be recovered

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20
Q

cannibalisation

A

new investment project decreases sales of existing business

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21
Q

IRR

A

discount rate for which NPV = 0

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22
Q

IRR decision rule

A

if IRR > r accept project

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23
Q

cases where NPV and IRR disagree

A

delayed investments, non existent IRR, multiple IRRs

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24
Q

payback period

A

only accept a project if its CFs repay initial investment within a pre specified period

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25
Q

problems with payback period

A

ignores cost of capital, ignores time value of money, ignores CFs after payback period, relies on ad-hoc decision criterion

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26
Q

multiple IRRs

A

there are as many IRRs as sign changes in CF stream

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27
Q

mutually exclusive projects

A

investing in one project necessarily excudes the toher

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28
Q

3 differences in projects that IRR ignores but NPV doesnt

A

differences in scale, differences in timing, differences in risk

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29
Q

incremental cash flows

A

a CF that takes place in one project but doesn’t happen at the same time in another project

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30
Q

incremental IRR

A

IRR of differences between projects. When discount rate = IRR one project stops being optimal and the other starts

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31
Q

problems with incremental IRR

A

difficult to interpret, don’t know which project is optimal when; doesn’t say if NPV > 0; doesn’t adjust projects for different amounts of risk

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32
Q

calculating NPV steps

A

1 - find unlevered income (before interest), 2 - use to find tax payable, 3 - convert accounting profits into annual CFs by making changes for non-cash items, 4 - discount CFs to present value, 5 - sum to find NPV

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33
Q

non-cash items

A

items in a profit and loss statement that relate to accounting entries instead of actual CFs - depreciation and amortisation, capital expenditure

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34
Q

capital expenditures

A

paid immediately while they’re subtracted from earnings over the lifetime of the project through depreciation

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35
Q

Net Working Capital

A

NWC = Cash + Inventory + Receivables - Payables

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36
Q

Free Cash Flow

A

FCF = (Revenues - Costs - Depreciation)(1 - Corporate Tax Rate) + Depreciation - Capital Expenditure - (Change in NWC)

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37
Q

NPV: Break-even analysis

A

how bad would one input have to go to make NPV = 0

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38
Q

NPV: sensitivity analysis

A

calculate how much NPV varies due to change in an input parameter, holding all others constant

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39
Q

NPV: scenario analysis

A

calculate effect of simultaneously changing more than one input parameter on NPV

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40
Q

Profitability Index formula

A

PI = PV of future cash flows / initial investment

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41
Q

Profitability index decision rule

A

PV > 1, accept

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42
Q

Annual percentage interest rate

A

doesn’t take into account effects of compound interest

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43
Q

effective annual percentage interest rate

A

reflects actual returns of investing

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44
Q

EAR formula

A

EAR = (1 + APR/k)^k - 1, where interest is paid k times a year

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45
Q

If r is the EAR in annualised terms…

A

equivalent n-month rate = (1+r)^(n/12) - 1

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46
Q

bond

A

debt instrument which is marketed in the form of securities of a fixed denomination

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47
Q

bond buyers

A

investors who want stable, predictable, low risk investments; pension funds; risk averse private investors

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48
Q

life cycle of a bond

A

1) bond issued by issuer: have a prospectus which defines t&c of bond. 2) initial bondholders buy bonds and give cash. 3) if its a coupon bonds, issuer pays interest payments called coupons to bondholder, if its a zero coupon bonds, no payment. 4) End of life of bond: issuer repays face value (specified at start), face value usually = denomination. If bond is a coupon bond, final coupon payment made at same time

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49
Q

fixed coupons

A

specified at outset

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50
Q

floating coupons

A

tied to variable rate

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51
Q

denomination relates to

A

traded units of bonds

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52
Q

face value relates to

A

cash flows

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53
Q

tenor

A

remaining length of life of bonds

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54
Q

coupon formula

A

[Coupon Rate x Face Value] / N.o. of coupon payments a year

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55
Q

default

A

when issuer fails to make coupon payments or face value payment on time

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56
Q

collateral

A

issuer’s assets which prospectus states can be seized by bondholders in event of default

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57
Q

unsecured bond

A

bond with no collateral

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58
Q

yield to maturity

A

overall profit of bond considering current price and future CFs - helps ot compare to other investments

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59
Q

2 ways to define YTM

A

1) discount rate at which: PV of all future cash flows = bond current price, 2) IRR of bond given current price

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60
Q

Bonds: if current price > face value

A

bond trading at premium - pay more now than receive later

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61
Q

Bonds: if current price = face value

A

bond trading at par - pay same now as receive later

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62
Q

Bonds: if current price <. face value

A

bond trading at a discount - pay less now than receive later, YTM > Coupon Rate

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63
Q

Bonds risks

A

default (but collateral is insurance), interest rates affect bond prices

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64
Q

shares risk

A

future dividends and company cost of equity are uncertain

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65
Q

Bonds vs. shares

A

bonds have lower risk and lower return than shares

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66
Q

Zero coupon bonds usually

A

trade at a discount

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67
Q

PV of zero coupon bonds

A

PV = Cn / (1+r)^n

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68
Q

YTM of zero coupon bonds

A

YTM = (FV/P)^(1/n) - 1

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69
Q

usually, a higher bond tenor =

A

higher yield to maturity

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70
Q

zero coupon yield curve

A

plots YTM against time to maturity - specifies discount rates for risk free CFs and acts as a potential indicator for future economic activity

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71
Q

bond prices and interest rate/YTM move

A

in opposite directions

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72
Q

zero coupon bonds issues by governments in developed markets…

A

yield a risk free rate of return as government cannot in theory default on domestic currency debt obligations

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73
Q

coupon bonds

A

pay face value at maturity and regular coupon payments

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74
Q

current market price is

A

sum of present value of all future CFs

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75
Q

Coupon Bond: PV(constant annuity)

A

= C/YTM [1 - (1/(1+YTM)^N)]

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76
Q

Coupon Bond: PV(face value at N)

A

= FV / (1+YTM)^N

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77
Q

price of coupon bonds in words

A

= PV(constant annuity) +PV(face value at N)

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78
Q

price of coupon bond formula

A

P = Coupon/YTM [1 - (1/(1+YTM)^N)] + [FV / (1+YTM)^N]

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79
Q

if we have semi annual coupon payments

A

need to express YTM is semi annual rate and ensure N is in 6 month periods

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80
Q

expectations

A

have major effects on investors willingness to lend or borrow for long term

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81
Q

steep yield curve indicates

A

short term interest rates expected to rise in future

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82
Q

inverted/decreasing yield curve indicates

A

expected decline in interest rates

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83
Q

nominal interest rate

A

not adjusted for inflation

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84
Q

real interest rate

A

adjusted for inflation

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85
Q

if inflation > 0

A

nominal rate > real rate

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86
Q

real interest rate equation

A

r_r = (1+r)/(1+i) - 1

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87
Q

fisher equation

A

(r-i)/(1+i) = r - i

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88
Q

3 main things that affect bond prices

A

changes in market interest rates (creates changes in YTM), time, bond paying a coupon

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89
Q

as interest rate/bond yields rise

A

bond prices fall

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90
Q

as interest rate/bond yields fall

A

bond prices rise

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91
Q

high coupon bonds vs. low coupon bonds

A

high coupon rates are less sensitive to YTM/IR changes. CFs of high coupon bonds arrive earlier so if YTM increases, the PV of CFs in near future decline a little but CFs in distant future decline a lot

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92
Q

short term bonds vs. long term bonds

A

bonds with shorter maturity rates less sensitive to YTM/IR changes

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93
Q

Maturity: a bond trading at discount

A

will increase in price as approach maturity

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94
Q

maturity: a bond trading at par

A

will stay the same price as approach maturity

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95
Q

maturity: a bond trading at premium

A

will decrease in price as approach maturity

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96
Q

dirty price

A

includes accrued interest rate for next coupon

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97
Q

clean price

A

adjusts for effect of receiving next coupon

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98
Q

to receive coupon, bondholder must buy bond before

A

ex-coupon date. on that date, bond price falls by coupon payment amount

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99
Q

the presence of default risk leads to…

A

increased required YTM

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100
Q

credit ratings

A

debtholders rely on Credit Rating Agencys to evaluate creditworthiness of issuers.

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101
Q

low bond rating =

A

higher risk and thus higher YTM

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102
Q

gordon growth model def

A

dividends grow at a constant rate forver

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103
Q

gordon growth model formula

A

P0 = Div1/(rE - g) or = [Div0 x (1+g)] / (rE - g)

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104
Q

r_E

A

equity cost of capital - discount rate used to discount future dividends - reflects riskiness of dividends - the return we expect for holding firm equity

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105
Q

rE formula

A

r_E = (Div1/P0) + g

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106
Q

dividend payout ratio

A

fraction of earning paid out as dividends

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107
Q

Dividend worded formula

A

= (Earnings / Shares Outstanding) x Dividend Payout Ratio

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108
Q

dividends can be increased by

A

increasing earnings or payout ratio

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109
Q

new investments formula

A

earnings x retention rate

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110
Q

change in earnings

A

New investments x return on new investments

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111
Q

earnings growth rate

A

change in earnings / earnings, OR, retention rate x return on new investments, OR (1 - dividend payout ratio) x return on new investments

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112
Q

retention rate

A

1 - dividend payout ratio

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113
Q

Simple dividend discount model: 1-year horizon. Price and rE formula

A

P0 = (Div1 + P1) / (1 + rE), rE = [(Div1 + P1) / P0] - 1 = Div1/P0 + (P1 - P0)/P0

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114
Q

Simple dividend discount model: n-year horizon. Price formula

A

P0 = Div1/(1+rE) + Div2/(1+rE)^2 + … + (Divn + Pn)/(1+rE)^n

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115
Q

two stage dividend discount model: First Stage

A

first stage until time t=N we predict each dividend individually by modelling company’s performance in detail -> High Growth Stage

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116
Q

two stage dividend discount model: Second Stage

A

from time t=N assume constant dividend growth which is usually low. Use gordon growth model to value share price at t=N -> Low/Terminal Growth Stage

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117
Q

two stage dividend discount model: Price formula

A

P0 = Div1/(1+rE) + Div2/(1+rE)^2 + … + DivN/(1+rE)^N + [1/(1+rE)^N] x [(1+g)DivN/(rE-g)]

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118
Q

total payout valuation model- words

A

firms can repurchase their shares rather than/in addition to paying out dividends.

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119
Q

total payout valuation model: Price Formula

A

P0 = PV(Future total dividends and repurchases) / Current shares outstanding

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120
Q

Enterprise Value, EV

A

present value of whole company

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121
Q

market value of equity

A

= price per share x number of shares = EV - debt value + cash

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122
Q

EV formula

A

market value of equity + debt value - cash

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123
Q

value of firms net debt

A

total debt - cash

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124
Q

Free Cash Flow

A

= EBIT(1 - Corporate Tax Rate) + Depreciation - Capital Expenditure - Change in NWC

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125
Q

FCF Waterfall

A

firm generate FCF; some FCF used on debt repayments; remaining FCF belongs to shareholders; some paid out in dividends; any leftover FCF reinvested in firm

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126
Q

when calculating PV of FCF we discount it with

A

Weighted average cost of capital (WACC)

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127
Q

discounted FCF model method

A

calculate EV of firm (PV of all future FCF); calculate equity value; divide market value of equity by number of shares to get predicted current share price

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128
Q

discounted FCF model: EV formula

A

= FCF1/(1+rWACC) + FCF2/(1+ rWACC)^2 + … + FCFN/(1+rWACC)^N + [1/(1+rWACC)^N x (1+g)FCFN/(rWACC - g)]

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129
Q

discounted FCF model: Price formula (EV)

A

EV0 + Cash - Debt / Shares Outstanding

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130
Q

price earnings ratio

A

used to compare firms: P/E ratio = share price / earnings per share

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131
Q

other multiples to compute firm value

A

enterprise value multiple (EV/EBIT(DA)); sales multiples (EV/Sales); price-to-book value of equity (P/BV)

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132
Q

EBITDA

A

earnings before interest, tax, depreciations, amortisation

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133
Q

EBIT

A

earnings before interest, tax

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134
Q

limitations of using valuation multiples

A

no clear guidance on how to adjust for differences across firms; provides info about firm relative to another but no info about overall mispricing

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135
Q

ESG Investing: environmental

A

climate change, environmental sustainability

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136
Q

ESG Investing: social

A

diversity and inclusion; human rights

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137
Q

ESG Investing: governance

A

corporate structure (Chair and CEO different?); executive and employee compensation structure

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138
Q

challenges to divestment strategy

A

difficulty and controversy in identifying firms; underperformance because divestment restricts investment universe, excluding potential high performenrs

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139
Q

comparison conducted based on key ESG factors

A

environment; community and society; employees and supply chain; customer; government and ethics

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140
Q

methods for applying ESG criteria

A

exclusion screen (excluding sin stocks); including only top ESG (in each industry); combination of methods - ratings often based on old info so asset managers do own research

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141
Q

dirty industry example

A

oil

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142
Q

clean industry example

A

pharmaceuticals

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143
Q

advantages of ESG investing

A

helps reduce cost of capital and thus cost of equity; reduces downside and overall risk so lower stock volatility

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144
Q

disadvantages of ESG investing

A

restricts investment universe and efficient frontier so may reduce maximum sharpe ratio - not able to access asset pricing factors that yield as much profit

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145
Q

ESG investings: financial motivation

A

lower risk - particulalry from regulatory uncertainties

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146
Q

ESG investings: non-financial motivation

A

ethical and environmental values; impact

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147
Q

green bonds

A

debt securities issued for specific projects designed to achieve environmental goals. issuer can be firms, banks, governments

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148
Q

green bonds features

A

usually have same credit rating as conventional bonds; YTM is lower - Green Premium - cheaper way for firm to borrow money. forego some returns and accept lower yields to pursue non-financial objectives

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149
Q

green vs. brown stocks

A

interest rate of green is lower - Carbon Risk Premium - firms face higher climate and regulatory risks so investors are compensated with higher expected return

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150
Q

green vs. brown portfolios

A

green portfolios outperform brown in realised returns over long term

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151
Q

return

A

increase in the value of an investment expressed in a percentage

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152
Q

probability distribution

A

assigns a probability that each possible return will orccur

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153
Q

return equation with prices

A

(Pt+1 - Pt)/Pt

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154
Q

expected (mean) returns

A

calculated as a weighted average of the possible returns where weights correspond to possibilities

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155
Q

Expected return formula

A

E[R] = ∑_RxP_R ×R

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156
Q

variance

A

expected squared deviation from the mean - measure of how spread out the distribution is

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157
Q

variance formula

A

var(R) = E[(R - E[R])^2] = ∑_RxP_R ×(R - E[R])^2

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158
Q

standard deviation

A

square root of the variance - the volatility of a return

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159
Q

variance and standard deviation do not differentiate between

A

upside and downside risk

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160
Q

realized return

A

return that actually occurred over a particular time period

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161
Q

realized return formula

A

Rt+1 = (Divt+1 + Pt+1)/(Pt) - 1 = Divt+1/Pt + (Divt+1 - Pt)/Pt

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162
Q

annual total realized return

A

1 + Rannual = (1+RQ1) (1+RQ2)(1+RQ3)(1+RQ4)

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163
Q

how can we estimates the underlying proability distribution

A

by counting the number of times a realized return falls within a particular range

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164
Q

empirical distribution is obtained when

A

the probability distribution is plotted against historical data

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165
Q

average annual return

A

R (bar) =1/T (R1+R2+⋯+ RT) = 1/T ∑R_t

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166
Q

variance of realized returns

A

Var(R) = 1/T-1∑(Rt - R(bar))^2

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167
Q

two problems with looking at historical data and realized return

A

we dont know what investors expected in the past, the average return is just an estimate of the expected return so we need to take into account an estimation error

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168
Q

standard error

A

statistical measure of the degree of estimation error

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169
Q

SD(Average of Independent, Identical Risks) =

A

SD(Individual Risk) / sqrt(Number of Observations)

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170
Q

the higher the standard deviation

A

the higher the standard error

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171
Q

the lower the number of observations

A

the higher the standard error

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172
Q

excess return (or equity risk premium)

A

difference between the average return for an investmenet and the average return for T-Bills (government bonds)

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173
Q

common risk

A

risk that is perfectly correlated and affects all securities

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174
Q

independent risk

A

risk that is uncorrelated and affects a particular security

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175
Q

diversification

A

the averaging out of independent risks in a large portfolio

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176
Q

firm specific news

A

good or bad news about and invidivual company

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177
Q

market wide news

A

news that affects all stocks, such as news about the economy

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178
Q

systematic risk

A

will affect all firms and not be diversified

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179
Q

risk premium for diversifiable risk

A

is zero so investors are not compensated for holding firm specific risk because they can diversify to eliminated it

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180
Q

risk premium of a security is determined by

A

systematic risk

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181
Q

how to determine how sensitive a stock is to systematic risk

A

look at the average chagne in return for each 1% change in the return of a portfolio that fluctuates solely due to systematic risk

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182
Q

efficient portfolio

A

portfolio that contains only systematic risk - no way to reduce volatility without lowering expected turn

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183
Q

a market portfolio is assumed to be

A

efficeint

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184
Q

Beta

A

is the sensitivity of the security’s return to the return of the overall market - the expected percentage change in the excess return of a security for a 1% change in the excess return of the market portfolio

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185
Q

volatility measures

A

total risk - systematic and unsystematic

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186
Q

beta is measure of

A

only systematic risk

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187
Q

market risk premium

A

the reward investors expect to earn for holding a portfolio with a beta of 1

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188
Q

risk premium formula

A

risk premium = beta x market risk premium

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189
Q

Capital Asset Pricing Model formula

A

E[R] = Risk Free Interest Rate + Risk Premium = rf + beta x (E[Rmkt] - rf)

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190
Q

portfolio weights formula

A

xi = Value of intestments / total value of portfolio

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191
Q

return on the portoflio

A

weighted average of the returns on the single stocks included in the portfolio, and the weights correspond to the portfolio weights

192
Q

return on the portfolio formula

A

Rp = X1R1 + X2R2 + … + XnRn

193
Q

expected return of a portfolio

A

E[Rp] = ∑ Xi E[Ri]

194
Q

covariance

A

expected product of the deviation of two returns from their means

195
Q

covariance formula

A

Cov(R1, R2) = E[(R1 - E[R1])(R2 - E[R2])]

196
Q

covariance from historical data formula

A

= 1/T-1 ∑ (R1 - R(bar)1)(R2 - R(bar)2)

197
Q

if covariance is positive

A

the two returns move together

198
Q

if covariance is negative

A

the two return move in opposite directions

199
Q

correlation

A

Corr(R1, R2) = Cov(R1, R2) / SD(R1)SD(R2)

200
Q

variance of return of portfolio

A

x_1^2Var(R1) + x_2^2Var(R2) + 2x_1x_2Cov(R1, R2)

201
Q

inefficeint portfolio

A

its possible to find another portfolio that is better in terms of both expected reutrn and volatility

202
Q

lower correlation means

A

lower volatility - shown graphically by a bend to the left of a greater degree

203
Q

short sale

A

investors sell a stock that they do not own then buy that stock back in the future

204
Q

short position

A

there is a negative investment in a security

205
Q

long position

A

positive investment in a security

206
Q

portfolio risk premium formula

A

E[Rp] - rf

207
Q

Sharpe ratio equation

A

Portfolio Excess Return / Portfolio Volatility = E[Rp] - rf / SD(Rp)

208
Q

the higher the sharpe

A

the better the risk-return combination

209
Q

the portfolio with the hgihest sharpe ratio

A

is the portfolio where the line from the risk-free investment is tangent to the efficeint frontier of risky investments - efficeint portfolio is portfolio with highest sharpe ratio

210
Q

Beta formula

A

SD(R1) x Corr(R1, Rp) / SD(Rp) = Cov(R1, Rp) / Var(Rp)

211
Q

increasing the amount invested in 1 will increase the Sharpe ratio of portfolio P if

A

expected returns exceeds the required return - E[R1] > rf + beta x (E[Rp] - rf)

212
Q

required retuns

A

expected return that is necessary to compensate for risk

213
Q

CAPM assumptions

A

1) investors can buy and sell all securities at competitive market prices (without taxes or transaction costs) and can borrow and lend at the risk free rate, 2) investors are rational so only hold efficeint portfolios, 3) investors have homogenous expectations

214
Q

when CAPM assumptions hold an optimal portfolio is…

A

combination of the risk free investment and the market portfolio

215
Q

capital market line

A

when the tangent line goes through the market portfolio

216
Q

expected return of a capital market line portfolio

A

E[Rxcml] = (1-x)rf + xE[Rmkt] = rf + x(E[Rmkt] - rf)

217
Q

under CAPM assumptions the best portfolios

A

are a combination of risk free investment and market portfolios

218
Q

beta < 1

A

less volatile than market

219
Q

beta > 1

A

more volatile than the market

220
Q

beta < 0

A

negatively correlated to market

221
Q

CAPM is a

A

single factor model, just one varibale (beta) explains differences in returns across securities

222
Q

security market line

A

all individual stocks with beta-expected return combinations must lie on this line

223
Q

an asset that offered an expected return above the SML

A

is unpriced and investors would immediately buy it driving up its price and driving down its expected return until it reached the SML

224
Q

stocks alpha

A

difference between stocks expected return and reuqired return

225
Q

portfolio beta

A

weighted average beta of all the securities in teh portfolio = ∑x_i β_i

226
Q

value weighted portfolio

A

portfolio in which each security is held in proportion to its market capitaliztion

227
Q

market capitalization (MV)

A

= number of shares outstanding x price per share

228
Q

value weighted portfolio weight formula

A

x = market value / total market value of all securities

229
Q

price weighted portfolio

A

portfolio that holds an equal number of shares of each stock, independent of their size

230
Q

risk-free rate

A

yield on US treasury securities

231
Q

linear regression that identifies the best-fitting line through a set of points is

A

(Ri - rf) = alpha + beta(Rmkt - rf) + e

232
Q

E[Ri] with alpha

A

= rf + beta(E[Rmkt] - rf) + alpha

233
Q

if alpha is positive

A

the stock has performed better than predicted by CAPM - above the SML

234
Q

if alpha is negative

A

the stock has performed worse than predicted by CAPM - below the SML

235
Q

alpha formula

A

alpha = E[Rs] - rs

236
Q

what does CAPM predict

A

investors would immediatley buy (sell) a positive (negative) alpha stock, driving up (down) their price and driving down (up) their expected returns until they reach teh SML

237
Q

portfolios consisting of small stocks

A

had higher average excess return than those consisting of large stock

238
Q

low B/M ratio

A

growth stocks - low or negative alpha

239
Q

high B/M ratio

A

value stocks

240
Q

market value

A

= dividend stream / cost of capital

241
Q

alpha formula with percentages

A

alpha = cost of capital - required return

242
Q

momentum strategy

A

buying stocks that have had past high returns and shorting stocks that have had past low returns

243
Q

reasons for persistent positive alphas

A

CAPM correctly computes the risk premium - positive alpha = positive NPV, but investors ignore either because theyre unaware or costs > NPV; CAPM does not correctly compute the risk premium - positive alpha are returns for bearing risk that CAPM does nto capture

244
Q

arbitrage pricing model

A

we can identify a collection of well-diversified portfolios from which the efficient portfolio can be constructed

245
Q

factor portfolios

A

portfolios that can be combined to form an efficeint portfolio

246
Q

arbitrage pricing model: risk premium formula

A

E[Rs] = rf + beta^F1(E[Rf1] - rf) + beta^F2(E[Rf2] - rf) + … + beta^FN(E[Rfn] - rf)

247
Q

self-financing portfolio

A

portfolio where we borrow funds at rf to invest in factor portfolio

248
Q

SMB portfolio

A

each year buys a portfolio of small stocks and finances this position by short selling a portfolio of big stocks has histroically produced positive risk-adjusted returns (+ alphas) - small-minus-big portfolio

249
Q

HML portfolio

A

each year buys equally weighted portfolio of stocks with high book-to-market ratio and finances this position by short selling an equally weighted portfolio of stocks with low book-to-market ratio, produced positive risk-adjusted return - high-minus-low portfolio

250
Q

PR1YR portfolio

A

each year, after ranking stocks by their return over the last year, buy high past returns stock (top 30%) and finances this by short selling low past return stocks (bottom 30%), produced positive risk-adjusted returns, prior one-year momentum portfolio

251
Q

E[Rs] with different portfolio types

A

= rf + beta^mkt(E[Rmkt] - rf) + beta^SMB(E[Rsmb]) + beta^HML(E[Rhml]) + beta^PR1YR(E[Rpr1yr])

252
Q

FFC model

A

SMB portfolio, HML portfolio, PR1YR portfolio

253
Q

limitations of FFC

A

according to FFC, a firm with low B/M ratio is less risky and will offer lower returns than firm with high ratio - e.g. new firms, are they low-risk?

254
Q

capital budgeting

A

process used to analyse alternative investments to decide which to accept

255
Q

role of financial manager

A

investment decisions, financing decisions, working capital management: ensure availability of cash

256
Q

current value of assets (V0)

A

= present value of expected future cash flow discounted at appropriate cost of capital k

257
Q

current value of assets formula

A

V0 = E(CF1)/(1+k) + E(CF2)/(1+k)^2 + … + E(CFt)/(1+k)^t

258
Q

cost of capital

A

return offered in financial markets on investments of equivalent risk - also called required (and expected) return

259
Q

r_WACC

A

= (E/E+D)rE + (D/E+D)rD - (D/E+D)rDtC

260
Q

why is the cost of debt reduced by corporate tax?

A

tax shield effect of debt: interest payments on debt are tax deductible, while dividend payments on equity arent. financing through debt saves the company paying taxes

261
Q

how to find cost of equity

A

construct market portfolio, obtain risk free rate for market risk premium, estimate beta, calculate (yearly) cost of equity capital

262
Q

how to find cost of debt

A

if firm has bonds: take YTM on long-term bond, if no bonds: add rating default-spread to risk free rate, if neither available: find interest rate from recent long-term bank loans of firm and/or calculate synthetic rating using credit rating agency’c capital ratio to proxy default spead

263
Q

unlevered cost of capital

A

WACC without tax-shield: rU = (E/E+D)rE + (D/E+D)rF

264
Q

required rate of return for an asset (firm) financed with equity and debt

A

r_WACC = (E/E+D)rE + (D/E+D)rD x (1- τ_C)

265
Q

WACC estimation in words

A

determine permanent sources of capital, estimate cost of each capital source, weight each component to determine WACC

266
Q

project evaluation in words

A

determine the free cash flows of the investment, compute WACC including tax benefit of leverage, compute value of investment by discounting free cash flows of investment using WACC

267
Q

using company WACC for new project assumes that

A

risk of new project is equivalent to risk of existing projects, new projects won’t cause the company’s optimal or target capital structure to change

268
Q

alternative method for calculating the division’s WACC

A

(d=D/V): rWACC = rU - dτCrD

269
Q

derivatives def

A

securities that derive their value from the price of other assets

270
Q

most prevalent used derivatives

A

options, futures, forwards

271
Q

call option

A

gives its holder the right but not the obligation to buy an asset: at the exercise or strike price; on or before expiration date

272
Q

exercise option to buy the underlying asset if

A

market value of asset > strike price

273
Q

call option payoff

A

Max [ 0, S_T - K]

274
Q

put option

A

gives the holder the right but not the obligation to sell an asset: at the exercise or strike price; on or before the expiration date

275
Q

exercise option to sell the underlying asset it

A

market value of asset < strike price

276
Q

put option payoff

A

Max [ 0, K - S_T]

277
Q

option premium

A

purchase price of the option

278
Q

exercise/strike price (K)

A

price at which you buy or sell the security

279
Q

in-the-money option

A

exercise of option produces positive cash flow: call: exercise price < asset price (K<S_T); put: exercise price > asset price (K>S_T)

280
Q

at-the-money option

A

exercise price and asset price are equal (K=S_T)

281
Q

out-of-the-money option

A

exercise of the option would not be profitable - call: exercise price > asset price (K>S_T); put: exercise price < asset price (K<S_T)

282
Q

expiration date

A

last date on which the option can be exercised

283
Q

american option

A

can be exercised at any time before expiration

284
Q

european option

A

can only be exercised on expiration date

285
Q

call - long

A

the right but not obligation to buy 100 shares of the underlying asset at a certain strike price –> hope stock price will rise

286
Q

call - short

A

the potential obligation to sell 100 shares of the asset upon demand

287
Q

put - long

A

the right not obligation to sell 100 shares of the underlying asset at a certain strike price

288
Q

put - short

A

the potential obligation to buy 100 shares of the asset upon demand

289
Q

on expiry date, option price equals

A

intrinsic value

290
Q

intrinsic value

A

option payoff if option expired immediately

291
Q

if the long call purchaser is gaining

A

the short call writer is losing

292
Q

option value =

A

stock price - exercise price

293
Q

valuation at expiration =

A

exercise price - stock price

294
Q

derivative markets

A

allow market participants to trade/reallocate different types of risk in the economy

295
Q

hedging (insurance)

A

reducing riskiness of cash flows

296
Q

speculation

A

betting

297
Q

protective put

A

long position in put held on stock you already own

298
Q

portfolio insurance

A

protective put written on portfolio rather than single stock

299
Q

straddles

A

put and call have same strike price

300
Q

strangles

A

call has higher strike price

301
Q

law of one price

A

in efficient market, identical securities (same PV of cashflows) must sell for the same price

302
Q

synthetic replication

A

invest in zero-coupon risk-free bond and European call option on same stock as in Protective put

303
Q

2 ways to construct portfolio insurance

A

purchase the stock and a put, purchase a bond and call

304
Q

law of one price equation

A

S (stock) + P (put) = PV(K) + C

305
Q

expression for price of a European call option for a non-dividend-paying stock

A

C = P + S - PV(K)

306
Q

price of call option for dividend-paying stock

A

C = P + S - PV(K) - PV(Div)

307
Q

put-call-parity

A

relationship between the value of the stock, the bond, and call and put options

308
Q

how factors affect European Call

A

+: stock price, risk-free rate, volatility. -: exercise price, dividends. ?: time to maturity

309
Q

how factors affect European Put

A

+: exercise price, volatility, dividends. -: stock price, risk-free rate. ?: time to maturity

310
Q

how factors affect American Call

A

+: stock price, time to maturity, risk-free rate, volatility. -: exercise price, dividends

311
Q

how factors affect American Put

A

+: exercise price, time to maturity, volatility, dividends. -: stock price, risk-free rate

312
Q

time value

A

difference between option’s price and intrinsic value

313
Q

what will always have a positive time value

A

any call option on non-dividend paying stock

314
Q

C =

A

S - K + dis(K) + P where dis(K) = amount of discount from face value of zero-coupon bond K

315
Q

binomial option pricing model assumption

A

each period, stock’s return can only take on two values

316
Q

replicating portfolio technique

A

option payoff in one period can be replicated by a portfolio consisting of a stock and a risk-free bonds

317
Q

binomial pricing tree: payoffs of replicating portfolios formula

A

Su∆ + (1+rf)B = Cu and Sd∆ + (1+rf)B = Cd where u is the up state and d is the down state

318
Q

binomial pricing tree: formula for ∆

A

∆ = (Cu - Cd) / (Su - Sd)

319
Q

binomial pricing tree: formula for B

A

B = (Cd - Sd)∆ / (1+rf)

320
Q

binomial pricing tree: value of the option formula

A

C = S∆ + B

321
Q

black-scholes option pricing model

A

technique for pricing european-style options when stock can be traded continuously, can be derived from binomial option pricing model by allowing the length of each period to shrink to zero and letting the number of period grow infinitely large

322
Q

black-scholes pricing model: example for finding N(d)

A

When d <= 0:
N(-0.1234) = N(-0.12) - 0.34[N(-0.12) – N(-0.13)] = 0.4505
When d >= 0:
N(0.6278) = N(0.62) + 0.78[N(0.63) – N(0.62)] = 0.7350

323
Q

black-scholes pricing model: N(d1) meaning

A

number of shares in tracking portfolio = delta

324
Q

black-scholes pricing model: -Ke^(-rT) N(d_2) meaning

A

risk-free borrowing = B

325
Q

5 inputs needed for black-scholes formula

A

stock price, strike price, exercise price, risk-free rate, volatility of the stock

326
Q

two strategies to find volatility

A

historical data, implied volatility

327
Q

implied volatility

A

the volatility of an asset’s returns that is consistent with the quoted price of an option on the asset

328
Q

capital structure

A

mix of securities which serves to divide cash flows between different classes of investors

329
Q

Modigliani-Miller model assumptions

A

capital markets are perfect, companies and individuals borrow at same rate, no taxes, no transaction costs, no issuance costs, no costs associated with company liquidation, companies have fixed investment policy

330
Q

M&M proposition 1

A

Capital structure does not impact firm value.

331
Q

M&M proposition 1 formula stuff

A

in perfect capital market, total value of firm equals market value of total cash flows generated by its assets and it not affected by choice of capital structure -> E + D = U = A where: E is market value of equity of levered firm; D is market value of debt of levered firm; U is market value of equity of unlevered firm; A is market value of firm’s assets

332
Q

digression

A

with perfect capital markets, financial transactions neither add or destroy value, but instead represent a repackaging of risk (and return) -> implies that any financial transaction that appears to be a good deal may be exploiting type of market imperfection

333
Q

M&M proposition 2

A

Equity risk increases with leverage, but overall firm risk (WACC) stays constant.

334
Q

M&M proposition 2 formula stuff

A

cost of capital of levered equity: rE = rU + (D/E)(rU - rD) where rU is expected asset cost of capital/compensation for business risk and the other component is compensation for financial risk

335
Q

if firm is unlevered…

A

all free cash flows generated by its assets are paid out to its equity holders. therefore, rWACC = rU = rA

336
Q

unlevered beta

A

market risk of firm’s underlying assets: βU = (E/E+D)βE + (D/E+D)βD

337
Q

two costs associated with the introduction of debt

A

direct cost of debt (explicit) - interest. indirect cost of debt (implicit) - increase rate of return required by shareholders

338
Q

interest tax shield =

A

corporate tax rate x interest payments

339
Q

M&M proposition 1 with taxes formula stuff

A

value of levered firm = value of unlevered firm of same risk class plus PV of tax saving. V_L = V_U + τ_c(D) where τ_c is the PV of the tax shield associated with interest payments

340
Q

M&M theory with taxes shows

A

firm value increases with leverage because of the tax shield of debt (WACC decreases)

341
Q

WACC with taxes

A

rWACC = (E/E+D)rE + (D/E+D)rD(1-τ_c)

342
Q

to receive full tax benefits of leverage…

A

firms need not use 100% debt financing. companies can use non-debt related tax shields - depreciation. Firm needs to have taxable earnings - no corporate tax benefit arises from interest payments about EBIT

343
Q

financial distress

A

when firm has difficulty meeting its debt obligations

344
Q

default

A

when firm fails to make required interest of principal payments on it debt

345
Q

bankruptcy

A

if asset value < liabilities. debt holders take legal ownership of firm’s assets

346
Q

leverage saves taxes but…

A

increases default risk

347
Q

2 types of bankruptcy costs

A

direct costs - fees to accountants, lawyers etc. indirect costs - lost sales, damage to reputation and management time spent attempting to avert bankruptcy

348
Q

trade-off theory of capital structure formula

A

V_L = V_U + τcD - PV(Financial Distress Costs)

349
Q

announcement of new equity interpreted as

A

signal that equity is overpriced - share price would decrease on day of announcement

350
Q

issuing debt involves

A

issuance costs and restricts firm flexibility through covenants

351
Q

pecking order theory assumptions

A

sticky dividend policy, a preference for internal funds, an aversion to issuing equity

352
Q

asset substitution problem

A

shareholders in company with outstanding debt own call option on assets of the company. managers have incentive to accept negative NPV projects with large risks if firm close to bankruptcy. call option values increase with increasing volatility. transfer of wealth from bondholders to shareholders.

353
Q

underinvestment problem

A

equity holders dont invest in positive NPV projects because firm is in financial distress and the value of undertaking the investment will accrue to bondholders rather than themselves. existing shareholders won’t contribute equity as first gains from investing in positive NPV projects accrue to debtholders. new shareholders won’t buy equity at existing price but require a substantial discount. existing shareholders reject this as their interests are diluted.

354
Q

debt overhang problem

A

too highly levered firm may not always choose positive NPV projects

355
Q

debt overhang problem extreme case: cashing out

A

when firm faces financial distress, shareholders have incentive to withdraw money from firm if possible - eg. sell assets below market value and pay dividend. potential solution - debt restructuring

356
Q

free cash flow problem

A

if FCF is not paid to out investors, managers more likely to abuse the funds for their own benefit - invest in negative NPV projects for growth, increase consumption of perquisites (corporate jet)

357
Q

free cash flow problem solution

A

increase leverage or pay higher dividends, aligns goals of management and shareholders through compensation

358
Q

value of the levered firm equation

A

V^L = V^U + PV(Interest Tax Shield) - PV(Financial Distress Costs) - PV(Agency Costs of Debt) + PV(Agency Benefits of Debt)

359
Q

tangible assets facts

A

in case of default value of tangible assets is easier to realise than that of intangible assets, debtholder’s risk is lower if company’s value is largely attribute to its tangible assets, companies with more tangible assets can borrow more

360
Q

general-use assets fact

A

general-use assets are easier to realise than that of firm-specific assets, debtholder’s risk is lower if company’s value is largely attribute to its general-use assets, companies with more general-use assets can borrow more

361
Q

payout policy

A

the way a firm chooses between alternative ways to distribute free cash flow to equity holders

362
Q

firms options of what to do with its free cash flow

A

retain: invest in new projects, increase cash reserves. pay out: repurchase shares, pay dividends

363
Q

two main types of dividend:

A

cash dividend: paid either quarterly or yearly. stock dividend: less common and resemble stock split

364
Q

declaration date

A

date on which the board of directors authorise the payment of the dividend

365
Q

record date

A

when a firm pays a dividend, only shareholders on record on this date receive the dividend

366
Q

ex-dividend date

A

a date, two days prior to a dividend’s record date on or after which anyone buying stock will not be eligible for the dividend

367
Q

payable date (distribution date)

A

a date, generally within a month after the record date, on which a firm mails dividend checks to registered stockholders.

368
Q

dividend timeline

A

declaration date -> ex-dividend date -> record date -> payable date

369
Q

what is a share repurchase

A

an alternative way to pay cash to investors is through share repurchase - the firm uses cash to buy shares of its own outstanding stock

370
Q

share repurchase: open market repurchase

A

when a firm repurchases shares by buying shares in the open market. 95% of all repurchase transactions

371
Q

share repurchase: tender offer

A

a public announcement of an offer to all existing security holders to buy back a specified amount of outstanding securities at a pre-specified price

372
Q

share repurchase: dutch action

A

firm lists different price at which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at each price

373
Q

share repurchase: targeted repurchase

A

when a firm purchases shares directly from a specific shareholder at a discounted or premium price

374
Q

share repurchase: greenmail

A

when a firm avoid a threat of takeover and removal of its management by a major shareholder by buying out the shareholder often at a large premium over the current market price

375
Q

signalling power of dividends

A

firms may use dividend increases to send positive signals to the market and dividend cuts can be seen as negative signals. share repurchases may be used to send positive signals since firms are likely to buy back own stock when it is undervalued.

376
Q

the dividend controversy

A

does the decision to pay a dividend change the value of the stock or is it just a signal to the markets?

377
Q

the dividend controversy: the neutral perspective overview

A

dividend policy doesn’t affect firm value.

378
Q

the dividend controversy: the neutral perspective detail

A

assumptions: perfect capital markets, no agency costs, individual investors borrow at same rate as firms, cash flows are perpetuities, two types of claim: debt (risk-free) and equity (risky), all firms same risk class, no bankruptcy costs. V0 = ∑_(t=1)^∞((E_t - I_t)/(1+K_e )^t ) - value of firm = PV of future cash inflows minus the PV of future cash outflows discounted at risk-adjusted discount. any change in dividend payment will lead to an equal and opposite change in the amount of funds raised from new shares. investors dont need dividends to get cash in hands, they can sell stocks, so investors wont increase their demand for stocks with higher dividends so market value of firm wont change because of increase in dividend paid

379
Q

perfect market view equations

A

P0 = (D1 + P1/1 + Ke), Ke = (D1/P0) + (P1 - P0/P0)

380
Q

the dividend controversy: the conservative perspective overview

A

an increase in the dividend payout increases firm value

381
Q

the dividend controversy: the conservative perspective detail

A

stock market in favour of liberal dividends. standard practice to evaluate common stock by applying one multiplier to that proportion of the earning paid out in dividends and a much smaller multiplier to the undistributed balance. these investors increase the price of the stock through their demand for a dividend paying stock

382
Q

the dividend controversy: the radical perspective overview

A

an increase in the dividend payout reduces firm value

383
Q

the dividend controversy: the radical perspective detail

A

income tax > capital gains tax, because dividends are taxed at income companies should pay the lowest dividend. effective dividend tax rate is: τd = (τd - τg / 1 - τg) where τg is capital gains tax. this measures additional tax paid by investor per dollar of after-tax capital gains income received as a dividend.

384
Q

the radical perspective investors preferences

A

INDIVIDUAL INVESTOR: tax disadvantage for dividends, generally prefer share repurchase (52%). INSTITUTIONS, PENSION FUNDS: no tax preference, prefer dividend policy that matches income needs (47%). CORPORATIONS: tax advantage for dividends (1%)

385
Q

if the radical perspective is correct, then why do firms bother paying dividends?

A

according to radicals, if companies regularly repurchase shares, then the authorities will tax these payments by income tax. so whenever companies repurchase shares, they try to find a good excuse to do so

386
Q

retain cash or pay it out as dividends?

A

in perfect capital markets (no taxes) it doesnt matter as long as excess cash is invested in zero NPV projects. corporate taxes make it costly to retain cash. firms can build cash holdings to pursue positive NPV projects without issuance costs. cash holdings reduce the likelihood of financial distress but agency costs

387
Q

put-call parity equation

A

P + S = C + Xe^(-rt) where P = value of put option, S = share price, C = value of call option, X = exercise price, t = time to maturity, r = risk free rate

388
Q

categories of real options

A

the timing option, the abandonment option, the expansion option

389
Q

the timing option

A

if no uncertainty, calculate NPVs for several dates in future and select date with highest NPV. with uncertainty, need to see whether its better to wait. Delay the project? - better conditions in the future (Lower interest rates), calculate value of option to delay and see whether value is > current NPV. Trade off: if you exercise now you lose the value of option to wait. if you keep option (wait) you lose possible positive cash flows of project today

390
Q

the abandonment option

A

if actual CFs are low, you have option to abandon project. option to abandon is equivalent to put option. Adjusted Present Value (APV) = NPV (assuming no abandon) + value of abandonment put option

391
Q

the expansion option

A

many investments have follow-on opportunities to expand at a later date. these add value to project even if the future expansion doesnt seem attractive today. the option to expand is equivalent to an out-of-the money call option. APV = NPV(assuming no expansion) + the value of the expansion call option

392
Q

profitability index rule

A

PI = NPV/Initial Investment. invest when index is at least 1

393
Q

the hurdle rate rule

A

raises the discount rate by using a higher discount rate than the cost of capital to compute NPV but then applied normal NPV rule. if project can jump the hurdle with positive NPV then it should be undertaken. Hurdle Rate = Cost of Capital x (Callable Annuity Rate / Risk-Free Rate) where callable annuity rate is the rate on a risk-free annuity that can be repaid at any time.

394
Q

sources of funding

A

angel investors, private equity firms, institutional investors, corporate investors

395
Q

angel investors

A

individual investors offering capital for a significant portion of equity

396
Q

private equity firms

A

limited partnerships, raising money to invest in private firms. often appoint their managers to boards of firms they invest in

397
Q

institutional investors

A

invest in private firms either directly or indirectly through VCs

398
Q

corporate investors

A

corporations invest in other firms for the returns and/or to achieve strategic objectives

399
Q

how do you exit from an investment in a private firm?

A

corporate acquisition - large firms could acquire the outstanding shares of the private firm. public offering - marking the firm public through an IPO

400
Q

advantages of going public

A

greater liquidity, better access to capital

401
Q

disadvantages of going public

A

less monitory therefore less control, costly and time-consuming information disclosure

402
Q

types of IPOs: types of shares

A

primary offering - new shares, company gets the money. secondary offerings - insiders selling their shares

403
Q

types of IPOs: mechanism used for listing

A

best efforts - underwriters do their upmost to list the company but they’re not contractually obliged to list the company. firm commitment - underwriter lists the company whatever the conditions. auction IPO

404
Q

mechanics of an IPO

A

find an underwriter, provide info to authorities (prospectus), value the firm (set up initial price range), build a book (road shows), price the deal and manage risk

405
Q

IPO puzzles

A

under-pricing - marked price always turns out to be higher than offer price, if you are allocated shares you make a gain on first day of trading. cyclicality - IPOs come in waves -> cost of underwriters -> firms do well in short run as offer price is below market price -> in long run IPOs tend to underperform. cost of issuing IPO. long-run underperfrmance

406
Q

mechanics of an SEO - Seasoned Equity Offerings

A

companies listed on market and been trading for years sometimes go to market to raise additional capital. many IPO steps still apply but no need for price setting. usually offered at a price below market price

407
Q

SEO kinds

A

cash offer - new shares to investors at large. rights offer - new shares to existing investors

408
Q

debt financing

A

interest on debt is tax deductible. debtholders face lower risk than equity holder thus cost of debt is lower than cost of capital. higher the debt on balance sheet, higher the probability of future default

409
Q

types of public debt

A

bearer bonds - cannot be traced. registered bonds - every owner is registered and all transactions are electronic

410
Q

types of corporate debt

A

notes - unsecured short term debt. debentures - unsecured long term debt. mortgage bonds - secured by real property, don’t own property until you pay mortgage off. asset-backed bonds - secured by any kind of asset. senior debt - priority in claiming assets when in default junior debt - in default, holders receive what’s left after senior debt

411
Q

types of bond markets

A

domestic bonds - issued and traded locally, open to foreign investors. foreign bonds - issued by foreign firm in local market and purchased by local investors. eurobonds - international bonds not in local currency. global bonds - combination of domestic, foreign and eurobonds.

412
Q

default risk facts

A

bond prices go down and promised interest rates go up when probability of default increases. in default, actual rates < promised rates

413
Q

junk bonds

A

bonds with high probability of default and therefore high yields.

414
Q

types of private debt

A

term loans - a loan that lasts a specific term and is funded by either one bank or a group of banks. private placements - a bond issue sold directly to a small group of investors, less costly to issue since its not registered

415
Q

types of debt other than corporate debt

A

sovereign debt - government debt, depending on maturity you can have bills, notes and bonds. asset-backed securities - the securities’ CFs are backed by CFs from other assets. municipal bonds - issued by local govs, several kinds including serial, general obligation, double-barrelled, revenue bonds.

416
Q

restrictive covenants

A

rules that prevent firm from increasing probability of going into default -> rules in order not to increase value of option to default. apply to dividends and new issues to debt: senior debt, secured debt

417
Q

repayment provisions

A

sinking funds - when part of the issue is repaid before maturity (firms makes regular payments to fund). callable bonds - call option that allows firm to pay back debt early. puttable bonds - put option that allows bondholder to demand early repayments

418
Q

convertible bonds

A

the right to convert (exchange) a bond for equity at a predetermined price. resembles a bond-warrant portfolio. Conversion Ratio - number of shares into which each bond can be converted. Conversion Price - bond’s face value over the conversion ratio

419
Q

exchange rate

A

amount of one currency needed to purchase one unit of another currency

420
Q

spot rate of exchange

A

exchange rate for an immediate transaction

421
Q

forward exchange rate

A

exchange rate for a forward transaction

422
Q

direct quotation

A

the exchange rate is given in number of units of the home currency per unit of the foreign currency

423
Q

indirect quotation

A

exchange rate is given in number of units of foreign currency per unit of home currency

424
Q

factors that affect exchange rates equations

A

e = f(∆INF, ∆INT, ∆INC, ∆GC, ∆EXP) where e is % change in spot rate

425
Q

∆INF

A

change in relative inflation rate

426
Q

∆INT

A

change in relative interest rate

427
Q

∆INC

A

change in relative income levels

428
Q

∆GC

A

change in government controls

429
Q

∆EXP

A

change in expectation of future exchange rates

430
Q

factors affecting exchange rates diagram

A

difference in interest rates (1+ £ interest rate / 1 + $ interest rate) === expected difference in inflation rates (1 + expected £ inflation rate / 1 + expected $ inflation rate) === expected change in spot rate (expected £ spot rate / currency £ spot rate) === difference between forward and spot rates (forward £ exchange rate / current £ spot rate)

431
Q

interest rate parity

A

as a result of market forces, forward rate differs from spot rate by an amount that offsets the interest rate differential between two currencies. Then, covered interest arbitrage is no longer feasible and the equilibrium state achieved is referred to as IRP

432
Q

IRP relationship equation

A

[F - S] / S = [S(1+p) - S] / S = p = (1+iH)/(1+iF) - 1 = (iH - iF)/(1 + iF). The approximated form p = iH - iF provides reasonable estimate when interest rate differential is small

433
Q

purchasing power parity

A

dollar price of goods in US = peso price of goods in ruritania / number of pesos per dollar. when a country’s inflation rate increases relative to that of another country, decreased exports and increased imports depress the high-inflation country’s currency

434
Q

absolute form of PPP

A

extension of the law of one price. suggests that the prices of the same products in different countries should be equal when measured in a common currency

435
Q

relative form of PPP

A

accounts for market imperfections like transportation costs, tariffs and quotas. states that the rate of price changes should be similar

436
Q

rationale of PPP theory

A

suppose UK inflation > US inflation. Higher UK imports from US and lower UK exports to US. Upwards pressure placed on $. This shift in consumption and the $’s appreciation continue against £ until: price of US goods >= price of UK goods in both countries

437
Q

PPP does not hold consistently due to

A
  1. Confounding effects - exchange rates are also affected by differences in expected inflation, interest rates, income levels, government controls. 2. Lack of substitutes for some traded goods
438
Q

relative nominal interest rates facts

A

relatively high interest rate may indicated expectations of relatively high inflation which may discourage foriegn investment. so, its important to consider the real interest rate which adjust nominal for expected inflation

439
Q

effects on exchange rates: relative interest rates equations - Fisher Effect

A

(1+R) = [(1+r)(1+E(i))] -> R = [(1+r)(1+E(i))] - 1 -> r = [(1+R)/(1+E(i))] - 1 where r = cost of capital in real terms, E(i) = expected annual inflation, R = cost of capital in nominal terms

440
Q

expectations theory

A

the forward premium/discounts are supposed to be unbiased predictors of the future spot rates (changes in spot rates)

441
Q

international fisher effect

A

since all investors require the same real return, differentials in nominal interest rates may be due to differentials in expected inflation. IFE suggests that currencies with higher interest rates will depreciate because the higher nominal interest rates reflect higher expected inflation. so, investors hoping to capitalise on a higher foreign exchange rate should earn a return no higher than what they would have earned domestically

442
Q

derivation of IFE

A

E(r_f), the expected effective return on a foreign money market investment should be equal to r_h, the effective return on a domestic investment. r_f = (1+i_f)(1+e_f) - 1. when the interest rate differential is small the IFE is e_f = i_h - i_f

443
Q

when does IFE not hold

A

since it is based on PPP, it will not hold when PPP doesn’t. if there are factors other than expected inflation that affect exchange rates, exchange rates may not adjust in accordance with the expected inflation differential

444
Q

fluctuations in exchange rates: importer-exporter dilemma

A

Consider a US firm that imports parts from Italy. if the supplier sets the price in euros, the US firm faces the risk that the dollar may fall, making euros and parts more expensive. if the supplier sets the price in dollar, the supplier faces the risk that the dollar may fall and it will receive fewer euros

445
Q

hedging with forward contracts

A

by entering into a currency forward contract, a firm can lock in an exchange rate in advance and reduce or eliminate its exposure to fluctuations in currency value. contract specifies: exchange rate, amount of currency to exchange, a delivery date

446
Q

potential problem with forward exchange rate contracts

A

the forward contract locks in the exchange rate and eliminates the risk whether the movement of the exchange rate is favourable or unfavourable.

447
Q

cash-and-carry strategy

A

strategy used to lock in the future cost of an asset by buying the asset for cash today and carrying it until a future date - eliminates exchange rate risk. Trades: borrow euros today using a one-year loan with interest rate r€ -> exchange the euros for dollars today at the spot exchange rate S -> invest the dollars today for one year at interest rate r$ -> in a years time the investor will owe euros and receive dollars

448
Q

covered interest parity

A

states that the difference between the forward and spot exchange rates is related to the interest rate differential between currencies. F = S x (1+r$ / 1+r€) -> ($ in a year / € in a year) = ($ today / € today) x [($ in a year/$ today) / (€ in a year/€ today)]. For no arbitrage forward exchange rate put both parts of last fraction to the power of T

449
Q

advantages of forward contracts over cash-and-carry strategy

A

simpler requiring one transaction rather than 3. many firms not able to borrow easily in different currencies and may pay higher interest if credit quality is poor

450
Q

hedging with options

A

say a one year forward exchange rate is $1.20 per euro. firm will need euros in one year can buy a call option on the euro giving it the right to buy euros at max price. if the spot exchange rate is < $1.20 per euro the firm will exercise the option and convert at spot rate. if the spot rate is > $1.20 per euro firm will exercise the option and convert $ to euro at $1.20 per euro. if the firm doesnt hedge, its cost for euros is the spot rate. if they hedge a forward contract it locks in the cost of euros and cost is fixed. if it hedges with option, it caps potential cost but will benefit if euro depreciates

451
Q

when would a firm use options instead of a forward contract

A

the firm can benefit if the exchange rate moves in their favour and not be stuck paying above market rate. the transaction they are hedging may not take place

452
Q

horizontal merger

A

target and acquirer are in same industry - volkswagen purchase of porsche

453
Q

vertical merger

A

target’s industry buy from or sells two acquirer’s industry - google acquired android

454
Q

conglomerate merger

A

target and acquirer are in unrelated industries

455
Q

acquisition premium

A

paid by an acquirer in a taken, the % difference between the acquisition price and the pre-merger price of target firms

456
Q

reasons to acquire - 13

A

LARGE SYNERGIES: cost reduction and revenue-enhancement - ECONOMIES OF SCALE: savings made from producing goods in high volume - ECONOMIES OF SCOPE: savings from combining the marketing and distribution - VERTICAL INTEGRATION: coordination - EXPERTISE: more efficient to purchase the talent as a functioning unit - TAX ADVANTAGE: losses in one division can offset profits in another - RISK REDUCTION: larger firms bear less unsystematic risk - DEBT CAPACITY AND BORROWING COSTS: large firms have lower probability of bankruptcy - ASSET ALLOCATION - LIQUIDITY - EARNINGS PER SHARE OF MERGED EXCEED THAT OF PRE-MERGER: even when merger itself creates no economic value - CONFLICTS OF INTEREST: managers prefer to run large company due to additional pay and prestige - OVERCONFIDENCE

457
Q

vertical integration

A

merger of two companies in same industry that maker products required at different stages of production

458
Q

takeover synergies

A

additional value created due to a merger

459
Q

mergers: the offer

A

once valuation is complete, make a tender offer. bidder can use two methods to pay for target: cash or stock. in cash, bidder pays for target in cash. with stock-swap transaction, bidder pays for target by issuing new stock and giving it to target shareholders - bidder offers to swap target stock for acquirer stock

460
Q

mergers: exchange ratio

A

number of bidder shares received in exchange for each target share

461
Q

mergers: board and shareholder approval

A

both target and acquiring board of directors must approve the deal and put the question to a vote of the shareholders of the target

462
Q

friendly takeover

A

when a target’s board of directors supports the merger, negotiates with acquirers and agrees on price that’s put to shareholder vote

463
Q

hostile takeover

A

situation in which an individual or organisation purchases a large fraction of target company’s stock and in doing so, gets enough votes to replace the target’s board of directors and CEO

464
Q

corporate raider

A

the acquirer in a hostile takeover

465
Q

takeover defences

A

PROXY FIGHT: acquirer attempts to convince target shareholder to unseat board by using proxy votes - POSION PILLS: a right offering that gives target shareholders the right to buy shares in either target or acquirer at deeply discounted price - STAGGERED BOARD (CLASSIFIED BOARD): board of directors have three year terms that are staggered so only 1/3 of directors are up for election each year - WHITE KNIGHT: target company looks for another company to acquire it - GOLDEN PARACHUTE: lucrative severance package that is guaranteed to a firm’s senior management in the event that the firm is taken over and managers let go - RECAPITALISATION: a company changes its capital structure to make itself less attractive as a target

466
Q

the leveraged buyout

A

corporate raider announces tender offer for half outstanding shares of a firm. instead of using cash to pay, the raider borrows money and puts the shares as collateral. if the offer succeeds, raider has control of company. law allows the raider to attach the loans directly to the firm. at the end, raider owns half the shares but the firm is responsible for repaying the loan

467
Q

why do acquirers choose to pay so large a premium?

A

competition. once an acquirer starts bidding on a firm it becomes clear that significant gains exist and other potential acquirers may submit their own bids. result is like an auction and target is sold to highest bidder

468
Q

interest rate risk

A

firms that borrow must pay interest on the debt. increase in interest rates raises the cost of borrowing and reduces profitability. many firms have long-term future liabilities - a fall in interest rate increases the PV of these liabilities and lowers PV of the firm.

469
Q

interest rate swap

A

contract in which 2 parties agree to exchange the coupons (interest payments) from two different types of loans. one party agrees to pay coupon based on a fixed interest rate in exchange for receiving coupons based on prevailing market interest rate during each coupon period. parties exchange a fixed-rate coupon for a floating-rate coupon. can reduce cost of borrowing and eliminate interest rate risk

470
Q

floating rate

A

interest rate that adjusts to current market conditions

471
Q

interest rate swap example

A

5 year, $100 million interest rate swap with 7.8% fixed rate. standard swaps have semi annual coupons so fixed coupon amounts would be 1/2 x 7.8% x $100 million = $3.9 million every six months

472
Q

interest rate swap facts

A

floating rate coupons based on the six month LIBOUR - calculated based on six month interest rate that prevailed in market six months prior to coupon payment date. each payment of the swap is the difference between the fixed and floating rate coupons.

473
Q

combining swaps with standard loans

A

interest rate a firm pays on its loans can fluctuate for 2 reasons: the risk-free interest rate in market may change, firm’s credit quality can vary. by combining swaps with loans, firms can choose which of these sources of interest rate risk they will tolerate and which they will eliminate

474
Q

swap and standard loan: net borrowing cost for firm

A

Net Borrowing Cost = Short Term Loan Rate + Fixed Rate Due on Swap - Floating Rate Received from Swap

475
Q

trade offs of long term vs short term borrowing

A

borrow long term at fixed rate: pro = lock in current low interest rate, con = lock in currency high spread given low initial credit rating. borrow short term: pro = get benefit of spread falling as credit improves, con: risk of an increase in interest rate

476
Q

incremental IRR rule technique

A

find the incremental cash flows - minus the two inflows and outflows from one another. find the IRR from the incremental cash flows. if the IRR > cost of capital, accept project with the higher initial investment

Year 2, Sem 1 (3 decks)

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