Key Questions Flashcards
in what circumstances is it more important to use multi-stage dividend discount models rather than constant-growth models?
Multi-stage dividend discount models should be used when valuing companies with temporarily high growth rates. These companies tend to be companies in the early phases of their life cycles, when they have numerous opportunities for reinvestment, resulting in relatively rapid growth and relatively low dividends (or, in many cases, no dividends at all). As these firms mature, attractive investment opportunities are less numerous so that growth rates slow.
With all else being held equal, a firm will have a higher P/E if its beta is higher. True, false or uncertain?
False: Higher beta means that the risk of the firm is higher and the discount rate applied to value cash flows is higher. The present value of the cash flows, and therefore, the price of the firm will be lower when risk is higher. Thus the ratio of price to earnings will be lower.
P/E will tend to be higher when ROE is higher (assuming plowback is positive). True, false or uncertain?
True: Higher ROE means more valuable growth opportunities. The growth rate of the firm will be higher.
P/E will tend to be higher when the plowback rate is higher. True, false or uncertain?
Uncertain: The answer depends on a comparison of the expected rate of return on reinvested earnings with the market capitalisation rate. If the expected rate of return on the firm’s projects is higher than the market capitalisation rate, then the P/E will increase as the plowback ratio increases. If it is lower, then the P/E will decrease as the plowback ratio increases.
What is the relationship between forward rates and the market’s expectation of future short rates? Explain in the context of both the expectations and liquidity preference theories of the term structure of interest rates.
In general, the forward rate can be viewed as the sum of the market’s expectation of the future short rate plus a potential risk (or ‘liquidity’) premium. According to the expectations theory of the term structure of interest rates, the liquidity premium is zero so that the forward rate is equal to the market’s expectation of the future short rate. Therefore, the market’s expectation of future short rates (i.e., forward rates) can be derived from the yield curve, and there is no risk premium for longer maturities.
• The liquidity preference theory, on the other hand, specifies that the liquidity premium is positive so that the forward rate is greater than the market’s expectation of the future short rate. This could result in an upward sloping term structure even if the market does not anticipate an increase in interest rates. The liquidity preference theory is based on the assumption that the financial markets are dominated by short-term investors who demand a premium in order to be induced to invest in long maturity securities.
Under the expectations hypothesis, if the yield curve is upward- sloping, the market must expect an increase in short-term interest rates. True/false/uncertain? Why?
True. Under the expectations hypothesis, there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future.
Under the liquidity preference theory, if inflation is expected to be falling over the next few years, long-term interest rates will be higher than short-term rates. True/false/uncertain? Why?
Uncertain. Expectations of lower inflation will usually lead to lower nominal interest rates. Nevertheless, if the liquidity premium is sufficiently great, long-term yields may exceed short-term yields despite expectations of falling short rates.
What does duration measure?
Duration is a measure of the time it takes to recoup one’s investment in a bond.
How does duration relate to maturity?
Duration is shorter than the maturity term on coupon bonds, as cash flows are received prior to maturity. Duration equals maturity for zero-coupon bonds, as no cash flows are received prior to maturity.
What variables affect duration?
Duration measures the price sensitivity of a bond with respect to interest rate changes. The longer the maturity, the lower the coupon rate, and the lower the bond’s YTM, the greater the duration.
How is duration used as a portfolio management tool?
Interest-rate risk consists of price risk and reinvestment risk. When interest rates change, these two risk components move in opposite direction. If duration equals the horizon date, the two types of risk exactly offset each other, resulting in zero net interest-rate risk. This portfolio management strategy is known as immunization.
• A problem with immunisation is that the portfolio is only protected against one interest rate change only. Once interest rates change, the portfolio must be rebalanced to maintain immunization. The trade off between transaction costs and not being perfectly immunized needs to be considered.
Briefly describe the difference between Listed and Unlisted Investment vehicles.
(i) Value – The value of a unit in a listed investment will be the last price it traded at on the exchange. The value of a unit in an unlisted investment is set by the fund; (ii) Tax - Unit holders of unlisted investments will be exposed to capital gains tax when other unitholders redeem their units and they do not receive dividend franking credits. The opposite occurs for unitholders of equivalent unlisted vehicles; (iii) Closed – Most listed investments are closed-end funds while unlisted investments are often open-end funds. Closed-end funds have a set amount of units while the number of units in open- end funds can change; (iv) Liquidity – Listed investments are typically more liquid than unlisted investments. Some unlisted investments have lock-up periods.
Briefly describe the 3 main components of the Investment Process
The investment management process involves planning, execution, and feedback. (i) Planning – Identify and specify the investor’s objectives and constraints, create the investment policy statement, form capital market expectations, and create the strategic asset allocation; (ii) Execution – Construct the portfolio based on the asset allocation, security selection and portfolio optimisation (i.e. to meet the return/risk objectives) and implement the construction; (iii) Feedback – Monitor the investor, economic and market input factors and rebalance the portfolio to maintain the strategic asset allocation. Evaluate the performance of the portfolio.
What does the CAPM aim to do?
The goal of the CAPM is to establish a fair rate of return for a security given its systematic risk. This allows for an efficient allocation of capital.
How is beta defined and what exactly does it measure?
Beta is defined as the ratio of the covariance of the asset return and market return and variance of the market return. It is a measure of systematic risk of an asset and can be used to measure the contribution of an individual asset to the total variance of the market portfolio. In the CAPM the risk premium of an individual asset/portfolio is proportional to the risk premium of the market portfolio.
