Lecture 2 Flashcards
What is the most important actor in the financial market?
Consumer. The consumer is the most important actor in any market economy as they buy and consume products, and use surplus income to purchase financial securities.
Define Limited Liability Partnership (LLP).
An LLP is a partnership where partners limit their fractions of concern/business, and each partner’s liability is limited to what they have invested.
It encourages investment by facing a maximum loss of 100% of what they’ve invested.
What is a corporation in financial markets?
A corporation is a legal entity with limited liability, often organized when broader ownership is desired.
It can enter contracts, and its officers are selected by a board of directors. Corporations can be publicly traded or privately held.
What is a crown corporation?
In Canada, a crown corporation is government-owned but may be set up to offer a service beyond maximizing profitability (e.g., Canada Post). It can sometimes go public, as in the case of Atomic Energy Canada Limited.
Explain the role of banks in financial markets.
Banks operate in capital markets and might grow into investment banks (IB).
They handle a variety of financial services, including managing funds through investment firms.
What are regulators, and give an example.
Regulators ensure the fairness and integrity of the financial markets.
An example includes the Ontario Securities Commission (OSC) and the Securities Exchange Commission (SEC) which oversee market operations.
What is the NPV method used for in finance?
The NPV (Net Present Value) method is used for valuing various investments or projects by discounting their expected cash flows to present value.
Define assets in the context of finance.
Assets are resources owned by a business or individual that are expected to bring future economic benefits.
Historically, assets included physical items like gold, silver, and IOUs, but now they largely consist of contractual assets like stocks and bonds.
What are stocks?
Stocks are financial securities that represent a share of ownership in a company.
They offer the holder a portion of the company’s profits and are typically bought and sold on stock exchanges.
What are bonds?
Bonds are financial instruments that represent a loan made by an investor to a borrower (typically corporate or governmental).
They bind the issuer to pay back the principal along with interest at a predetermined schedule.
What does it mean when an asset is described as “transferable” and “immaterial”?
Assets that are transferable and immaterial can be freely bought and sold without physical exchange, often existing mainly as entries in electronic records or legal documents, rather than as physical items.
Give examples of ancient and modern forms of assets.
Ancient assets included gold, silver coins, and IOUs, while modern assets include stocks and bonds, which are often purely contractual and stored electronically.
What happens to profits retained by a company?
Profits retained by a company are channeled into Retained Earnings on the balance sheet, which increases the value of the firm and thus the share price.
What is a dividend in the context of stock investments?
A dividend is a distribution of a portion of a company’s earnings to its shareholders as decided by the board of directors.
Explain the difference between common shares and preferred shares.
Common shares typically confer one vote per share and might receive dividends variably.
Preferred shares often provide no or limited voting rights but offer more stable dividends and higher priority during bankruptcy liquidation.
What is a treasury share?
Treasury shares are stock that a company has bought back from shareholders.
They do not affect the company’s value like slicing a pizza into fewer slices, each representing the same total pizza.
What is an IPO?
An IPO (Initial Public Offering) is when a company first offers its shares to the public, facilitated by a syndicate of financial intermediaries.
What happens when a company goes insolvent?
If a company becomes insolvent and files for bankruptcy, it must settle all liabilities before shareholders can receive any residual value, making shareholders lower priority compared to debt holders.
What is the Discounted Cash Flow (DCF) method?
The DCF method is a valuation technique used to estimate the value of an investment based on its expected future cash flows, adjusted for the time value of money.
What does the growing perpetuity formula in stock valuation look like?
The growing perpetuity formula for valuing a stock is given by: PV = D1 / (r - g), where D1 is the dividend expected next period, r is the required rate of return, and g is the growth rate of dividends.
Calculate the price of a stock expected to pay a $5 dividend next year that grows at 3% annually with an 11% required return.
Using the formula PV = D1 / (r - g),
substitute D1 = $5, r = 0.11, and g = 0.03:
PV = $5 / (0.11 - 0.03) = $62.50 (Note: slight discrepancy due to rounding in the original calculation).
What is the Discounted Dividend Model (DDM)?
The DDM is a method used to estimate the value of a stock by discounting expected dividends to their present value.
It assumes dividends will grow at a constant rate indefinitely.
How to calculate the value of growth opportunities for a stock?
The value of growth opportunities can be calculated as the difference between the stock price including growth and the price as a constant perpetuity.
For example, if the stock price with growth is $64.31 and without growth is $45.46, the value of growth opportunities is $64.31 - $45.46 = $18.85.
What happens to the stock price in a zero growth scenario according to DDM?
In a zero growth scenario, where g = 0%, the stock price can be calculated as PV = D0 / r. If D0 = $5 and r = 0.11, then PV = $5 / 0.11 = $45.45.
What is a bond in finance?
A bond is a type of debt or liability where the issuer owes the holders a debt and is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity.
What are the characteristics of bonds?
Bonds typically involve
regular coupon payments,
a fixed interest rate,
a defined term of loan (maturity),
and the repayment of face value at maturity.
They may be zero-coupon, meaning they do not pay periodic interest.
How is the price of a coupon-paying bond calculated?
The price of a coupon-paying bond can be calculated using the formula:
PV = C[1 - (1 + r)^-N]/r + FV/(1 + r)^N, where C is the annual coupon payment, r is the discount rate, N is the number of years to maturity, and FV is the face value of the bond.
What does it mean if a bond is trading at a discount?
A bond is trading at a discount when its market price is lower than its face value.
This typically happens when the bond’s coupon rate is lower than the current market interest rates.
What does it mean if a bond is trading at a premium?
A bond is trading at a premium when its market price is higher than its face value.
This occurs when the bond’s coupon rate is higher than the current market interest rates.
How do interest rate changes affect bond prices?
Bond prices are inversely related to interest rates.
If interest rates decrease, bond prices increase, and vice versa.
This is because the present value of the bond’s future cash flows becomes more valuable as rates fall.
What is the relationship between a bond’s coupon rate and its trading condition at par?
A bond trades at par (face value) when its coupon rate equals the market discount rate.
Explain how a bond price is recalculated when interest rates change using an example.
For a bond with an original price of $859.53, a coupon of $50, and a yield drop from 7% to 4%, the new price would be calculated as the sum of the discounted future cash flows using the new yield, resulting in a higher bond price of $1074.35.
What are GICs (Guaranteed Investment Certificates)?
GICs are fixed income securities issued by sovereigns (governments) that guarantee the return of the principal and a fixed interest rate.
They are considered low-risk and are primarily used for capital preservation.
What are U.S. Treasury Bills (T-bills)?
U.S. Treasury Bills, or T-bills, are short-term government securities that mature in less than a year.
They are issued at a discount from the face value and do not pay interest before maturity.
What is the significance of the yield on Treasuries and GICs?
The yield on Treasuries and GICs is generally low because they are backed by governments and considered very low risk.
Their price is high relative to the payments they promise, emphasizing safety over high returns.
Explain the 100-age rule used in personal finance.
The 100-age rule suggests that individuals should subtract their age from 100 to determine the percentage of their portfolio that should be allocated to stocks, with the remainder in bonds. This rule aims to balance risk and security through life stages.
What is a junk bond?
Junk bonds are bonds rated as below investment grade.
They offer higher yields due to higher risks associated, including the increased likelihood of default.
How can bonds be riskier than stocks?
Bonds typically considered safe can become risky, especially if issued at an extreme discount (deeply discounted junk bonds, for instance).
These bonds may have high yields that are reflective of high risks, potentially making them as risky or riskier than stocks.
What are Bankers’ Acceptances (BAs)?
Bankers’ Acceptances are short-term financial instruments issued by a company but guaranteed by a bank for future payment.
They are often sold at a discount and traded in secondary markets, implying a small positive interest rate.
What is Commercial Paper?
Commercial Paper refers to unsecured, short-term debt issued by corporations to finance their operations.
It is similar to a credit card for the company, sold at a discount to face value, and typically carries a higher risk and therefore a higher return than BAs.
Explain Municipal Bonds.
Municipal bonds are issued by local government entities like cities to fund public infrastructure projects. They often enjoy tax-favored status, meaning the income they generate is tax-exempt or reduced, encouraging investment in these bonds.
What is a unique requirement for Quebec cities regarding municipal bonds?
Quebec cities must issue debt through the provincial government, which has specific policy implications and effects on the municipal financing landscape.
How to calculate the implied effective annual rate of return on a discounted commercial paper?
The formula used is PV = FV / (1 + r)^n.
Rearranging to find r when you know the present value (PV), future value (FV), and the term (n), allows you to calculate the annualized rate of return.
Calculate the implied effective annual rate of return for a commercial paper with a face value of $3 million, sold for $2.7 million, maturing in 4 months.
Using the formula r = [(FV / PV)^(1/n) - 1], where FV = 3, PV = 2.7, n = 1/3 (4 months as a fraction of a year),
r = [(3/2.7)^(3) - 1] = 37.17%.
What is a mutual fund?
A mutual fund is an investment vehicle composed of a pool of funds collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets.
Mutual funds are managed by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors.
What is the purpose of diversification in mutual funds?
Diversification in mutual funds helps to keep risk (standard deviation) low while maintaining returns by spreading investments across various assets, which can individually have higher costs and risks if purchased alone.
