Implied Returns And Cash Flow Additivity Flashcards
When it comes to fixed income, when the price of the bond decreases, the yield to maturity…..
Increases and vice versa when the the price of the bond increases, the yield to maturity decreases
The Required Rate of Return on equity is the ratio of
The expected annual dividend
_______________________________
current price
(AKA - the Share’s Dividend yield)
The Implied Growth Rate is
the Required Rate of Return - the Dividend Yield
Ke - D1/V0
D1 is expected div
V0 is stock current share price (today)
Cash Flow Additivity Principle refers to the fact that the
PV of any stream of cash flows equals the sum of PVs of the cash flows
(Doesn’t matter how you math it up)
[Insert function: N, I/Y, PV, PMT, FV]
A security will make the following payments at the end of the next four years. $100, $100, $400, and $100. Calculate the PV of these cash flow flows using the concept of the PV of an annuity when the appropriate discount rate is 10%
For the annuity:
N=4, I/Y=10, PV (cpt), PMT=100, FV=0
PV =316.99
For the Single Payment
N=3, I/Y=10, PV (cpt), PMT=0, FV=300
PV=225.39
PV of the sum of PV’s = 542.38
The basis for the No-Arbitrage Principle, or “law of one price,” which says that
two sets of future cash flows are identical under all circumstances, they will have the same price today
(if they don’t, investors will quickly buy the lower priced one and sell the higher priced one, which will drive their prices together)
Three examples of valuation based on the no-arbitrage condition are
Forward interest rates, forward exchange rates, and option pricing using a binomial model
Forward Interest Rate is the
Interest rate for a loan to be made at some future date.
The notation used must identify both the length of the loan and when in the future the money will be borrowed
Re. Future Interest Rates
1y1y is the rate for…
a 1year loan to be made one year from now
Re. Future Interest Rates
2y1y is the rate for…
A 1year loan to be made 2 years from now
Re. Future Interest Rates
3y2y is the rate for…
a 2yr forward rate three years from now
Spot interest rate contrasts from a forward interest rate because
a Spot Interest Rate is an interest rate for a loan to be made today.
Any combination of Spot and Forward Interest Rates that cover the same time period should…
have the same cost
The future rate that can be locked in today is a
Forward Rate
An Exchange Rate is
the price of one country’s currency in terms of another country’s currency.
Ex: 1.416 USD/EUR means
the one Euro is worth 1.416 dollars
In this example the numerator or the price currency is USD and the denominator or the base currency is the EUR
an Option is
the right, but not the obligation, to buy or sell an asset for a specified price on a future date
The right to buy an asset is ____ option and the right to sell an asset is a _____ option
Right - buy
Put - sell
A call option will let the option expire if
the underlying asset can be bought in the market from less than the price specified in the option
A put option owner will let the option expire if
the underlying asset can be sold in the market for more than the price specified in the option
a Bionomial Model is based on the idea that,
over the next period, some value will change to one of two possible values
To construct a one-period binomial model for pricing an option, we need the following:
1) a value for the underlying asset at the beginning of the period
2) an exercise price for the option
3) returns that will result from an up-move and a down-move in the value if the underlying over one period
4) the risk-free rate over the period
Ex:
An investment of $5mm today is expected to produce a one-time payoff to $7mm three years from today. The annual return on this investment, assuming annual compounding, is
(7/5)^1/3 - 1
