Investments Flashcards
survival ratio and wealth ratio
survival ratio:
(salary income + asset income) / total expenses >1
wealth ratio:
asset income / total expenses > 1
What are prerequisites for investing
already having cash savings and adequate insurance coverage
what are common reasons why people invest?
- income (retired people)
- major expenditures (saving for college, house..)
- retirement resources
- shelter from taxes
how do you determine the amount of investment capital?
it all depends on the expected average annual rate of return
what is the capital market
a market facilitating the flow of surplus of funds from lenders/investors to those in deficit borrowers/issuers
what are characteristics of the capital market?
securities maturity >1 year
difference btwn primary and secondary capital markets
primary: financial securities newly issued
secondary: financial securities already issued
what securities are there in a capital market?
equity: common stocks
debt: bonds
hybrid: preferred stocks, convertible preferred stocks, convertible bonds
what are bonds?
bonds are long term debt instruments in which a borrower agrees to make payments of principal and interest on specific dates to a lender
what is equity?
equity represents ownership of a firm, residual claim after all liabilities are paid
who is the principal and who is the agent in corporation?
principal: shareholders
agent: management
main difference between common and preferred stock:
dividends are fixed for preferred stock (still not guaranteed like in bonds), it also has higher seniority, no control, and lower liquidity
what is the main difference between preferred stocks and bonds?
dividends of preferred stocks can be omitted without the fear of pushing the firm into bankruptcy. preferred stocks also offer higher returns
what are convertible securities?
securities that allow for the conversion into common stock at pre-specified terms. they usually offer lower interest than non convertible counterparts
what is the tradeoff every investor faces?
- risk reward
- high current income vs capital appreciation
which formula explains best the risk return tradeoff?
return = risk free rate + risk premium
which risks come with investing?
- business risk: uncertainty regarding future cash flwos and the firms ability to meet operating expenses
- financial risk:
possibility that the firm will not sufficient cahs flows to meet debt obligations - market risk:
results from swings in security prices - purchasing power: changes in the level of prices and inflation
- interest rate:
especially for bonds - liquidity:
risk of not being able to liquidate
which types of return are possible when investing?
- current income
- capital gains
- interest on interest
what makes for a good investment?
when approximate yield > desired rate of return
approximate yield formula
(annual CI + [Pt - P0]/N) / [(P0 + Pt)/2]
Difference between secured, subordinated, and guaranteed bonds
secured bonds are backed by collateral, guaranteed bonds are backed not only by the issuer but also by a third party, subordinated bonds are lower in priority
which types of bond issuers are there?
governments, state enterprises, corporates
rank claimants in order of repayment
- senior bonds
- normal bonds
- subordinated bonds
- preferred stocks
- common stocks
what is a trustee?
the bondholders’ representative appointed to oversee collateral backing a secured bonds
what are callable bonds?
bonds that give the issuer the opportunity of early prepayment at pre specified terms (for example in case of credit rating upgrades or falling interest rates)
callable bonds have a higher discount rate, and a declining call premium
What are putable bonds?
give the holder the right to be prepaid earlier and redeem the bonds, should the issuer not sustain some pre specified conditions
which bond rating criteria do you know?
- financial ratios (coverage, liquidity, profitability)
- bond contract terms (secured or not, coventants..)
- qualitative factors like earning stability, political factors
what rating are junk bonds?
lower than BBB
relationship between discount rate and coupon rate on bond valuation
r = c, sold at par
r < c, sold at premium
r > c, sold at discount
how do you compute approximate yield to maturity?
YTM = current annual income + [(par - purchase price)/N] / [(purchase price + par value)/2]
DDM
D1 / (r - g)
what influences cost of equity?
market rates
market risk aversion
firm’s leverage
firm’s business risk
