Mid term 2 Flashcards
How do you find the price of any financial asset at any time?
The value of any financial asset is equal to the present value of all future cash flows from that asset
What is the definition of a business in BUS 314
A combination of assets, that when operated, should generate net cash.
What are the four components of the formula for interest
R = r + h + mp+ dp R = nominal interest rate r = real interest rate h = Expected inflation mp = maturity premium dp = default premium
If the real interest rate drops from +1% to -1% what would you expect would happen to nominal interest rate?
They would fall by 2%
If expected inflation, currently around 1.5% suddenly rose to 7% what would you expect to happen to nominal interest rates?
They would rise (7 - 1.5) = 5.5%
Would you normally expect to pay a higher rate of interest on a 20 year mortgage or a 30 year mortgage? Name the concept that comes into play.
Higher rates on the 30 year.
The concept is “Maturity Premium”, the idea that the longer a lender ties up money with a borrower, the greater the return the borrower seeks
What is the name of the concept that explains why people who already have bad credit scores and have already gone bankrupt end up paying higher interest rates on their credit cards than do those with impeccable credit history?
Default premium - the more likely a borrower is to default, the greater the return a borrower demands
What does APR, and APY and EAR stand for?
Financially which is more accurate?
APR - Annual Percentage Rate - starting rate
APY - Annual Percentage Yield - What you get
EAR - Effective Annual Rate - What you pay
APY / EAR are more accurate, that is what you really pay
If you could earn 1% per week on your money i.e. if your deposit were to be compounded weekly at 1% what would your APR be? What would your APY be?
52%
67.8%
What is the coupon yield on a bond?
It is the coupon / face value of the bond. Usually the face value is 1,000. So if the bond paid 100 per year, the coupon yield would be 10%
What is the Yield to Maturity (YTM) of a bond?
The YTM is the discount rate that, when applied to find the Present Value of all future payments expected from a bond, gives you the price of the bond.
Bond relationship #1: if interest rates rise, all else being equal, what happens to bond prices?
Bond prices will fall. in general bond prices move in opposite to interest rates
Bond relationship #2: if you have two bonds with the same coupon yield, but one matures in 5 years and the other matures in 10 years, which bond price will be more sensitive to changes in interest rates?
the 10 year maturity - all else being equal, the longer the bond maturity, more sensitive the binds price is to changes in the interest rates
Bond relation’s #3; if you have two bonds with the same YTM, but one has a 10% coupon yield and the other has a 1% coupon yield, which bond will be more sensitive to change in interest rates?
the bond with the 1% coupon yield would be more sensitive. all else being equal, the lower the coupon yield, the more sensitive. The more sensitive bonds for any given maturity would be zero - coupon bonds.
If a bond is trading at a premium to its coupon rate, what do you know about the relationship between the coupon rate and the yield to maturity (YTM)
The yield to maturity will be below the coupon rate
Why are municipal bonds attractive to high - income investors
Because you typically do not have to pay taxes on the interest you earn from municipal bonds
What sort of bonds were at the very center of the 2008 - 09 financial crisis
Mortgage backed bonds
Give two ways banks traditionally lowered the default risk on their mortgage. these two standards were largely abandoned during the 2008/09 financial crisis
- 20% down payment on the house price paid initially by the borrower to provide an equity cushion
- check to confirm loan applicant actually has a job and that mortgage payments would not be an excessive burden given the income
What is the difference between the primary and secondary markets for stocks
Primary markets are where the company sells stocks to the public. at that time the company actually raises money for the business
Secondary markets are the markets for “used” stock. Investors trade shares among themselves, but the company itself receives nothing from these trades
Here are three variables in the gordon growth equation. all else being equal, what direction must each of the following move to make the price of a stock go up;
- Next Year’s dividend
- the expected growth rate of the dividend
- the return that an investor expects to receive from an investment in the shares
- a higher next year’s dividend raises the value of the stock
- A higher growth rate for the dividend raises the value of the stock
- the lower the return an investor expects to receive from an investment in the shares, the higher the value of the stock
What are the two cash flows that most investors expect to receive from a stock, which allow you to analyze a stock much like a bond?
- Dividend, which are much like the coupons on a bond
- the selling price when you get rid of the stock. this is much like the principal being returned at the expiration of a bond
Stocks are often referred to as ‘residual’ rights. What does the residual right mean should a firm go bankrupt?
the stockholder’s are last in line for assets of the firm. The bond holders get ‘made whole’ first. in a typical bankruptcy, the shareholders get nothing
Stocks are often referred to as ‘residual rights’. How could this residual status affect what happens when a firm wants to reward shareholders with a dividend?
The stockholders are last in line for the assets of the firm. all obligations to the bondholders must be met and up to date before any money is available to the shareholders as dividends. if a firm is failing to meet its debt obligations, it must cut its dividends and pay the coupons and principal that it owes the bondholders first.
How is risk understood in finance theory?
Risk is measured as volatility. Typically expressed as standard deviation
Stocks historically have produced average returns of 10% per year with a standard deviation of 20%. What range of returns would you expect to receive in 2/3 of the years that you ere invested in the stock market?
The average (+10%) plus or minus 1 standard deviation, so the range would be between -10 and -30
Imagine a graph of different portfolio, with returns mapped to the y - axis and risk (standard deviation) mapped to the x - axis
- if two portfolios have the same risk, which portfolio is closer to the efficient frontier
- If two portfolios have the same return, which portfolio is closer to the efficient frontier
- If two portfolios have the same risk, select the one with the higher yield
- if two portfolios have the same return, select the one with the lower risk
James Tobin’s “Seperation Theorem” suggests that every investor should own the same mix of assets in his/her portfolio. If that is the case, how should an investor control for risk?
To reduce risk, an investor holds more cash and allocates less in the efficient portfolio. To try for a higher return, an investor puts more money into the portfolio and holds less cash.
Roughly how many stocks must you own to remove all the unsystematic risk?
N = 20
Here is the formula for the Capital Asset Pricing Model
Ri = rf + Beta(rm-rf) + alpha + ei
What does each term stand for?
Ri = Security Return rf = Risk free rate Beta = sensitivity returns to market returns rm = Expected market rate of returns alpha = abnormal return beyond or below prediction of CAPM Ei = the residual - firm specific factors that can be diversified away
