Intro to Fin

Question 1

i. Business is inherently volatile. Does this mean that business people are risk seekers?

Answer 1

No, business people are risk averse. They accept the inherent volatility of business if they are sufficiently compensated for the volatility.

Question 2

i. If someone is described as risk averse does that mean that they would never take a risk?

Answer 2

A risk averse person would not avoid risk altogether. They would take a risk if they were sufficiently compensated for the risk.

Question 3

i. If someone was described as risk averse, would they tend to invest if they saw the stock market as a ‘fair game’ investment?

Answer 3

No. There is no long term gain or loss. However the risk averse need a positive long term gain for entering in to the investment. Although there is no long term loss on average, they would rather avoid the risk. Although the average gain and the average loss are exactly the same, there is more ‘pain’ from the loss than there is ‘pleasure’ from the gain. Therefore a risk averse person would never take a fair bet.

Question 4

i. What is a fair bet or fair game?

Answer 4

A fair bet is a gamble or investment where the participant is left neither better or worse off over many trials. The classic fair game is a coin toss with a 50/50 chance of winning or losing exactly the same amount depending on whether the coin comes up heads or tails. However, note that this is not the only kind of fair game as we will see in the next question.

Question 5

i. What are debt and equity, and what is the fundamental distinction between the two?

Answer 5

• debt – Is paid interest. Debt holders lend money to the firm. They do not own the firm and do
  not vote.
• Equity – participates in ownership of the firm. Receives dividends. Dividend gets paid out of any surplus. Dividend does not have to be paid. Equity comes last for payment when firm is wound up.

Question 6

What are the potential advantages of debt relative to equity for the firm?

Answer 6

• Ít risky cho investors
• Required return on debt is lower than equity => Debt is a cheaper form of capital
• The issue costs of debt are lower than that of equity
• Debt doesn;t give away ownership of the firm
• Interest payment on debt reduces taxable profit => Interest payments reduce the tax bill

Question 7

What are the main characteristics that define a bond?

Answer 7

• Coupon rate (is the percentage of the face value that is paid as interest before the principal is repaid.)
• face value (is the units in which the bond is nominally issued)
• maturity (is the number of years from the time of issue to the time when the bond expires)
• frequency of payment (semi-annual coupon payment)
  The investor may also be interested in the default rate.

Question 8

What is the role of bond rating agencies in financial markets?

Answer 8

To estimate quality of bond, likelihood of default and therefore risk of the bond. The rating agencies operate various schemes such as AAA etc which give the quality of the bond and indicate the risk and required return. Anything below B is junk or ‘fallen angel’ and is high risk and less than investment grade

Question 9

What is an annuity cash flow?

Answer 9

An annuity cash flow is a recurring cash flow with a finite life.

Question 10

How can the annuity factor help in the valuation of bond cash flow?

Answer 10

The coupons from the bond are an annuity cash flow. Therefore they can be valued using one single annuity factor rather than many discount factors.

Question 11

What is a perpetuity cash flow?

Answer 11

A perpetuity cash flow is a recurring cash flow with a infinite life.

Question 12

How does the concept of perpetuity cash flow help in the valuation of a share with a constant
dividend?

Answer 12

The share can be seen as a perpetuity cash flow as the firm does not undertake to pay back the principal sum borrowed when the share was issued. However, shareholders should receive a dividend for all shares held. Effectively the stream of divs is a perpetuity cash flow.

Question 13

Outline and discuss the efficient markets hypothesis with particular reference to the techniques
of technical analysis and fundamental analysis.

Answer 13

Market price should encapsulate all available information. Market price is best estimate of true value of firm.
Price is not predictable in any meaningful way.
Individual should not be able to consistently make abnormal returns. i.e. Returns greater than one would normally expect from holding a portfolio of stocks over the long run.

Question 14

A derivative instrument is one which is derived from some underlying asset. True or false?

Answer 14

true

Question 15

All derivatives are based on some form of forward contract

Answer 15

True

Question 16

A forward contract là gì?

Answer 16

is a contract in which the counterparties agree to exchange the underlying at a defined date in the future but at a price decided now.

Question 17

A commodities forward contract là gì?

Answer 17

is a contract in which the counterparties agree to exchange a commodity at some date in the future but at a price decided now.

Question 18

Lợi ích của A commodities forward contract ?

Answer 18

food processing companies were able to know in advance what they would be paying for basic inputs such as wheat

Question 19

A futures contract ?

Answer 19

is different from a plain vanilla forward contract in that it comes in a variety of standardised forms and is exchange traded.

Question 20

A plain vanilla forward contract ?

Answer 20

is a private tailor-made contract between two counterparties, normally arranged by a broker.

Question 21

The advantages offered by a futures contract over a forward contract are as follows ??

Answer 21

• Firstly, it is easier to find a counterparty to a standardised market traded contract. As a consequence, the futures contract cuts down on search and information costs.
• ## Secondly, the terms and conditions of the futures contract are already known and there is no need to draw up a contract from ‘scratch’. Hence the futures market cuts down on contract cost

Question 22

Vì sao A forward or futures contract can change in value before the delivery date ?

Answer 22

• This is because as the future unfolds and more information becomes known, the counterparties will have a better idea of what the actual market price (spot price) is going to be
• And whether they have agreed to exchange at a favourable or foolish exercise price (strike price).

Question 23

The problem with a forward contract ?

Answer 23

it may be difficult to know precisely how valuable the contract is, given that it is private and not exchange traded

Question 24

Clearly if it emerges that the exercise price is favourable, the contract will become more valuable vì sao?

Answer 24

This is because of the potential for profit from the difference

Question 25

While if it begins to appear that the contract was a foolish bargain, it will become less valuable vì sao?

Answer 25

Because futures contracts are exchange traded, the value of the contract is usually more precisely known through price discovery

Question 26

4 main forms của derivatives?

Answer 26

• Forward contracts
• Futures contracts.
• Options: An option gives the purchaser the right but not the obligation to buy or to sell at the exercise price.
• Swaps: An exchange of cash flows, for example in different currencies

Question 27

Outline the basic nature of financial risk and how it is managed.

Answer 27

Financial risk can be measured by the range of potential outcomes. This is usually measured by the standard deviation of investment outcomes and can be illustrated using coin tosses ‘investments’. Risk averse investors do not like higher standard deviation of outcome, as any upside in the form of the possibility of high returns is more than cancelled out by the symmetrical possibility of higher loss. First class students would mention portfolio theory and the Capital Asset Pricing Model.

Question 28

Discuss the main contribution of Modigliani and Miller to financial theory.

Answer 28

Modigliani and Miller’s main contribution was to point out that firm value should be determined by the Net Present Value of project CF. Therefore, dividend policy and capital gearing should make no difference to the firm’s value. First class students would go on to describe the key role that perfect competition and perfect information play in their theory. In real life, both gearing and dividend policy may have an influence

Question 29

Outline and discuss the basic reason for using forward contracts.

Answer 29

• A forward contract is a contract in which the counterparties agree to exchange the underlying at a defined date in the future but at a price decided now
• ## Vd food processing companies were able to know in advance what they would be paying for basic inputs such as wheat

Question 30

fundamental equilibrium exchange rate ?

Answer 30

(FEER) is the exchange rate which is consistent with a balance of supply and demand measured on this basis

Question 31

Purchasing Power Parity (PPP) là gì?

Answer 31

Purchasing Power Parity, is based on the idea that the equilibrium exchange rate can be seem as the equilibrium ratio of currencies, and that this ratio can be established on the basis of relative prices.

Question 32

Compare and contrast two theories of exchange rate determination?

Answer 32

Kể ra FEER vs PPP

Question 33

Types of Forex Quotes?

Answer 33

• A bid rate is the price at which the market is prepared to buy a nominated currency (or any other financial asset).
• An ask (or offer) rate is the price at which the market is prepared to sell a nominated currency (or any other financial asset).
• A spot rate is the current market price for currency exchanges taking place now. (Or indeed any other financial exchange taking place now).
• A forward rate is the current market price for currency exchanges taking place at some predetermined point in the future. (Or indeed any other financial exchange taking place in the future). Different forward rates are normally quoted for different future exchange dates
• A central rate is an average of the bid and ask rates.

Question 34

Write short notes defining three money market instruments.

Answer 34

• Treasury Bill is typically issued by sovereign governments. Bill is secured on tax revenues.
• Certificates of Deposit, Fixed maturity and interest. Usually issued by banks.
• Certificate of deposit is a promissory note issued by a bank.It is atime deposit that restricts holders from withdrawing funds on demand.Although it is still possible to withdraw the money, this action will oftenincur a penalty.
• Commercial Paper – Unsecured and typically issued to finance working capital.
  commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation’s promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks’ rates.[1]