Mid term 2

Question 1

How do you find the price of any financial asset at any time?

Answer 1

The value of any financial asset is equal to the present value of all future cash flows from that asset

Question 2

What is the definition of a business in BUS 314

Answer 2

A combination of assets, that when operated, should generate net cash.

Question 3

What are the four components of the formula for interest

Answer 3

R = r + h + mp+ dp
R = nominal interest rate
r = real interest rate
h = Expected inflation
mp = maturity premium 
dp = default premium

Question 4

If the real interest rate drops from +1% to -1% what would you expect would happen to nominal interest rate?

Answer 4

They would fall by 2%

Question 5

If expected inflation, currently around 1.5% suddenly rose to 7% what would you expect to happen to nominal interest rates?

Answer 5

They would rise (7 - 1.5) = 5.5%

Question 6

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.

Answer 6

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

Question 7

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?

Answer 7

Default premium - the more likely a borrower is to default, the greater the return a borrower demands

Question 8

What does APR, and APY and EAR stand for?

Financially which is more accurate?

Answer 8

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

Question 9

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?

Answer 9

52%

67.8%

Question 10

What is the coupon yield on a bond?

Answer 10

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%

Question 11

What is the Yield to Maturity (YTM) of a bond?

Answer 11

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.

Question 12

Bond relationship #1: if interest rates rise, all else being equal, what happens to bond prices?

Answer 12

Bond prices will fall. in general bond prices move in opposite to interest rates

Question 13

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?

Answer 13

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

Question 14

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?

Answer 14

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.

Question 15

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)

Answer 15

The yield to maturity will be below the coupon rate

Question 16

Why are municipal bonds attractive to high - income investors

Answer 16

Because you typically do not have to pay taxes on the interest you earn from municipal bonds

Question 17

What sort of bonds were at the very center of the 2008 - 09 financial crisis

Answer 17

Mortgage backed bonds

Question 18

Give two ways banks traditionally lowered the default risk on their mortgage. these two standards were largely abandoned during the 2008/09 financial crisis

Answer 18

1. 20% down payment on the house price paid initially by the borrower to provide an equity cushion
2. check to confirm loan applicant actually has a job and that mortgage payments would not be an excessive burden given the income

Question 19

What is the difference between the primary and secondary markets for stocks

Answer 19

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

Question 20

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;

1. Next Year’s dividend
2. the expected growth rate of the dividend
3. the return that an investor expects to receive from an investment in the shares

Answer 20

1. a higher next year’s dividend raises the value of the stock
2. A higher growth rate for the dividend raises the value of the stock
3. the lower the return an investor expects to receive from an investment in the shares, the higher the value of the stock

Question 21

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?

Answer 21

1. Dividend, which are much like the coupons on a bond
2. the selling price when you get rid of the stock. this is much like the principal being returned at the expiration of a bond

Question 22

Stocks are often referred to as ‘residual’ rights. What does the residual right mean should a firm go bankrupt?

Answer 22

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

Question 23

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?

Answer 23

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.

Question 24

How is risk understood in finance theory?

Answer 24

Risk is measured as volatility. Typically expressed as standard deviation

Question 25

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?

Answer 25

The average (+10%) plus or minus 1 standard deviation, so the range would be between -10 and -30

Question 26

Imagine a graph of different portfolio, with returns mapped to the y - axis and risk (standard deviation) mapped to the x - axis

1. if two portfolios have the same risk, which portfolio is closer to the efficient frontier
2. If two portfolios have the same return, which portfolio is closer to the efficient frontier

Answer 26

1. If two portfolios have the same risk, select the one with the higher yield
2. if two portfolios have the same return, select the one with the lower risk

Question 27

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?

Answer 27

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.

Question 28

Roughly how many stocks must you own to remove all the unsystematic risk?

Answer 28

N = 20

Question 29

Here is the formula for the Capital Asset Pricing Model

Ri = rf + Beta(rm-rf) + alpha + ei
What does each term stand for?

Answer 29

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