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FIN 621 > Midterm Exam > Flashcards

Midterm Exam Flashcards

1
Q

Arbitrage

A

If two assets result in identical future cashflows but are priced differently, then an arbitrage opportunity exists.

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2
Q

Define asset

A

A sequence of cashflows

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3
Q

Short Selling

A
  • Profit from a price decline by
    a) borrowing stock through a dealer
    b) Sell it and deposit proceeds and margin (50%) in an account where you may get no interests
    c) Closing out the position: buy the stock and return it to the party from which it was borrowed
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4
Q

Premium Bonds

A

You purchase above par value. Your yield to maturity will be lower than coupon rate

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5
Q

Effect of interests

A

If interest increases, both assets and liabilities decrease. Assets decrease in value more than liabilities.

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6
Q

Junk Bonds

A

Anything less than an S&P, BB, Moddy’s Ba is a junk bond.

AKA: High-yield bond

Two types:

  • Original issue junk (possibly rated)
  • Fallen angels: rated
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7
Q

Beta

A

the covariance between the return of a stock and the return of the market portfolio, divided by the variance of the return on the market portfolio.

Beta is normalized covariance with the market portfolio.

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8
Q

Beta Values

A

B=0, we have the risk free asset
B=1, we have the market portfolio
B=2, we have an asset two times as risky the market
b=.5, we have an asset half as risky as market

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9
Q

Measuring systematic Risk

A

We want to know how a particular stock covaries with the market portfolio.

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10
Q

Leverage and returns

A

buying on margin amplifies risk and return. Investing borrowed money is called using leverage.

Doubling amount you invest by matching your own money with borrow money doubles your risk and risk premium.

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11
Q

Beta of the market

A

=1

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12
Q

When does re-investment create value?

A

If ROE is higher than required return

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13
Q

Free cash flow analysis

A

Discounted cash flow method

-Dollars in minus dollars out after taxes

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14
Q

Order to a Broker Requirements

A
  • What security to buy or sell
  • size of order
  • type of order (market, limit, stop, stop limit)
  • time limit (day, good-till-cancelled)
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15
Q

Net working capital

A

Total current liabilities - total current assets

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16
Q

Market Portfolio Risk

A

You can approximate by S&P 500

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17
Q

If you want lower risk, then you

A

want to invest in a portfolio of low correlation.

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18
Q

Business decisions

A
  • You cannot manage what you cannot measure
  • Valuation is the starting point for management
  • Once value is established, management is easier

Objectives + Valuations = Decisions

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19
Q

Minimum variance portfolio

A

Only focus on part of graph above this point AKA “efficient frontier”

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20
Q

Investment

A

An exchange of cash flows for cash flows

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21
Q

Buying on Margin

A

The equity in your account at the start is the amount you invested. Gains on stocks increase your equity, losses decrease your equity.

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22
Q

In a very diversified portfolio,

A

you don’t care about individual st deviation, you care about correlation between assets

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23
Q

Beta of Portfolio

A

Weighted average of the individual betas

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24
Q

Diversification

A

Makes a portfolios risk lower than either individual asset risk

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25
Q

Investment Opportunity Set

A

A chart that is shaped like a “C”

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26
Q

Low-coupon vs High-Coupon

A
  • Bonds purchased at a premium perform better when interest rates rise, discount bonds perform better when interest rates falls
  • If interest rates rise, the larger coupon of the premium bonds is reinvested at higher rates.
27
Q

Discount Bonds

A

You purchase below par value. Your yield to maturity will be higher than the coupon rate.

28
Q

P/E of S&P 500

A

A good estimate historically for the P/E of the S&P 500 is 19 minus inflation

29
Q

Regression to estimate Beta

A

Beta = Line of best fit

30
Q

Ask Price

A

Price asked by market to sell toy (offered price)

31
Q

Margin Accounts

A

Allow investors to leverage their money by borrowing from their broker

32
Q

What is corporate finance?

A

Corporate finance addresses these three issues:

1) what long-term investments should the firm engage in?
2) How can the firm raise the money for the required investments?
3) How much short-term cash flow does a company need to pay its bills?

33
Q

One basis Point

A

= .01%

34
Q

Goals of For-Profit Org.

A

1) primarily concerned with satisfying stockholders

2) The primary financial goal is to maximize shareholder wealth

35
Q

Initial Margin

A

The minimum amount needed to purchase on margin is currently 50% of the value of the purchased security (set by Fed Reserve)

36
Q

Capital Structure Decision

A

How to divide a firms equity and debts. This can effect how much wealth an organization

37
Q

Role of Financial Manager

A

1) Raise funds from investors
2) Invest funds in value-enhancing projects
3) Manage funds generated by operations
4) Return funds to investors
5) Reinvest funds in new projects

38
Q

Corp Bond Provisions

A
  • Seniority: Standing in bankruptcy (seniors is always most valuable)
  • Call features: attractive to lenders, less attractive to borrowers
  • convertibility: more valuable to investors
  • Covenants: rules/restrictions to protect bond holders
39
Q

Formula for Discounted cash flows

A

CF of N / (1+i)^n

40
Q

Using Beta to Invest

A

If you think market is going up, you want to invest in high beta stock.

If you think the market goes down, you want to invest in low beta stocks.

41
Q

ROA

A

Return on assets

net income/assets (equity + liabilities)

42
Q

Sustainable Growth Rate

A

g=ROE*Retention ratio

ROE (NI/Equity) * 1-dividend per share/earning per share

43
Q

Best borrowing decision

A

Lowest expected all-in cost with the greatest flexibility

44
Q

Not-for-Profit Corps

A

1) Service to the community (all stakeholders)

2) The primary financial goal is to ensure the financial viability of the organization

45
Q

Return on Stocks

A

Dividends (paid quarterly) and Capital gains (accrue when stock is sold)

r=D/p (dividend yield) = p1-p0/p0 (capital gains yield)

46
Q

Corporate bond yields

A
  • Normally higher than gov’t, so lower price

- Usually compared by the corporate yield spread (corporate yield - treasury yield)

47
Q

Bond risk

A

Sources: Changes in interest rates and changes in credit quality

Interest rate risk:

  • long-term bonds are riskier
  • Low-coupon bonds are riskier
  • Long-maturaity zero-coupon bonds are riskiest
48
Q

Correlation

A

A number between -1 and positive 1.

+1 means that the returns of two assets are in perfect sync.
-1 means that the returns of two assets are complete opposite
0 means uncorrelated returns

49
Q

Constant Growth model

A 
Assumes: 
-Dividends are infinite
-growth rate is constant
-Discount rate is greater than growth rate
p0=D1/(r-g)

If g>r, answer will be (-) even though it should be infinity.

50
Q

Preferred Stock

A

Called a hybrid form of financing.
Similar to bond, it has a par value and fixed dividend.
Similar to stock because dividend may be omitted if no dividends are paid to common shareholder, and company does not have to file bankruptcy.

51
Q

Types of orders

A

Market orders: buy at best (asked price) or sell at best (bid price). Always executed, but price is uncertain. Demand Liquidity.

Limit Orders: Buy a stock but only if you can buy at $x or less or sell at $x or more. Sometimes gets executed, but when it does, price is certain. Supply liquidity.

Stop Orders: Sell at $X, becomes a market order as soon as the specified price is hit

Stop Limit Orders: If prices goes below $X (stop price), order becomes a limit order to sell at $X (limit price) or better.

52
Q

What effects default risk?

A
  • Financial performance (debt ratio, coverage ratios, etc)
  • Provisions in bond contracts
  • Outside factors (regulatory environment, etc)
53
Q

P/E

A

Price per share divided by the earning per share

P/E is not affected by the # of shares outstanding.

54
Q

Immunization

A

A strategy that matches durations of assets and liabilities so as to make net worth unaffected by interest rate movements.

55
Q

Sharpe Ratio

A

Risk premium divided by standard deviation

It is the reward to bearing risk per unit of risk

56
Q

Efficient Market Hypothesis

A

Everything is equally and actually priced.

Fundamental values reflect expected future cashflows and discount rates

57
Q

Value Creation

A

growth creates value if and only if the return on investment exceeds the cost of capital.

58
Q

Levels of Security for bonds

A
  • Secured debt (senior then junior)

- Unsecured debt: (senior, subordinated, preferred stock, common stock)

59
Q

Bonds (relationships between price and yield)

A

Increase in price = decrease in yield

Decrease in price = increase in yield

60
Q

Bid Price

A

Price the market is bidding to buy from you

61
Q

Market Value of Company

A

Market Equity Value

Stock price * # of market shares

62
Q

Yield to Maturity

A

It is the annualized rate of return over the life of the bond. Under the assumption that all bond coupons are reinvested at the interest rate of YTM.

63
Q

ROE

A

on return on equity is constant over time.

Calculate by taking: Net Income/Equity

FIN 621 (2 decks)

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