Module 6 Flashcards
examples of security markets?
bond and stock markets
what 3 things do security markets do?
- bring buyers and sellers together
- reduce the cost of b&s (helps operational efficiency)
- provides a trading location
what is market equilibrium price?
the price that balances the overall demand and supply for a security
what is the intrinsic price?
PV of the CF an investor can expect to receive in future
what is the market price?
consensus price of all traders
characteristics of an efficient market?
- information efficiency
- low cost, easy to transact (operational)
- market price = intrinsic price
characteristics of an inefficient market?
- opposite of efficient
- market prices deviate from intrinsic prices by a huge margin
what is a bond?
it is a long-term security issued by comps, govs, municipalities, in order to borrow from the public.
two parties to a bond?
- borrower / issuer / seller
- lender / investor / buyer
what is a coupon payment?
the periodic interest the borrow is obligated to pay to the bondholder
what obligations do bond issuers have?
- to pay bondholders fixed interest amounts / coupons
- to pay the principle sum on maturity
advantages of bonds?
safer and less risky than shares
int and capital sum are guaranteed
disadvantages of bonds?
lower returns than shares
types of corp bonds?
- vanilla/straight bonds
- zero-coupon bonds
- convertible bonds
- callable/puttable and perpetual bonds
what is a vanilla/straight bond?
- coupon payments are fixed for bond life
- entire original principle paid at maturity
what is a zero-coupon bond?
- single pmt at maturity
- int paid to the bondholder is the difference between the principle amt and current amount received @ maturity
what is a convertible bond?
converted into ordinary shares at some predetermined ratio
what is a non-redeemable bond?
- bond in perpetuity
- no redemption date, pays coupons indefinitely
- principle not paid back
what is a redeemable bond?
- fixed lifespan, pays coupons up to maturity date
- full principle paid back at maturity
what is the face value of the bond?
paid / rec when the bond matures
what is the yield to maturity?
- represents the return required by investors on a particular bond
- used as a discount rate
- fluctuates with market conditions/int rates
how is the YTM derived?
- from the yields of similar instruments in the market
- when int rates inc, they inc
what is the process of valuation?
- process of determining how much an asset is worth
- we get fair value and intrinsic value from it
why do we value bonds?
- to determine its intrinsic value
- to discount all future coupons using the YTM as the discount rate
what techniques do we use to value financial assets?
discounted CF techniques = finding the PV of the future benefits (CF) of an asset
when should we trade financial assets?
- intrinsic value > market price = buy (underpriced)
- market price > intrinsic value = sell (overpriced)
- market price = intrinsic value (hold)
what is the relationship between bond price and YTM?
there is a negative relationship to ensure that existing bonds continue to offer the return demanded by investors/equal to similar bonds
what will a change in YTM without a corresponding price change mean?
a return different from what shareholders want
what does an inc in YTM mean?
investors want a higher return = less demand = price drops till YTM is equal to the higher yield wanted
what does a dec in YTM mean?
investors expect a lower return = huge demand = price increases till YTM is equal to lower yield wanted
what is interest rate risk?
relates to uncertainty about future bond values that is caused by the volatility of int rates
what is the default risk?
the probability that the borrower can fail to meet a condition of the contract which results in default
what causes markets to be efficient?
market prices of securities traded reflect all available info relevant to the security
types of secondary markets?
- direct search
- brokers
- dealers
what is a direct search?
individuals bear the full cost of locating and negotiating. it is very costly. infrequent b&s.
what is a broker?
brings b&s together and charges a commission fee less than direct search cost. increases market efficiency.
what is a preference share regarded as?
a fixed income security because div is fixed
general characteristics of a preference share?
- receive divs before OSH
- have pref on sharing of surplus assets on liquidation before OSH
- do not have voting rights
preference shares as equity?
- equity position
- fixed dividend
- ranked second priority
- div payment can be postponed or forgone
bonds as debt?
- debt position
- fixed int / coupon
- first priority
- coupon has to be paid at stipulated date or default
types of pref shares?
nonredeemable (cumul, non-cumulative)
redeemable
general characteristics of an ordinary share?
- represent ownership int in the comp
- voting rights
- divs when declared
- share surplus on assets @ liquidation
advantages of OS?
- outperform bonds and long term instruments
- easy to buy and sell
- info is easily available
- variety of firms
disadv of OS?
- higher risk
- divs not guaranteed
ordinary shares as equity?
- equity position
- rank last
- no fixed CF
- no fixed lifespan
three versions of the DDM?
- zero growth model
- constant growth model
- non-constant growth model
limits of the constant growth model
- assumption is unrealistic
- only applies to comps paying divs
- if g > R, shares get negative value
when would a non-constant growth model be suitable?
for firms currently experiencing high div growth which is followed by a lower but stable growth rate in divs later
