READING 2 THE TIME VALUE OF MONEY IN FINANCE Flashcards
Why are lower risky cash flows worth more?
Because lower discount rate
With a pure discount instrument, the investor pays less than the face value to buy the instrument and receives the face value at maturity.
The price the investor pays depends on the instrument’s yield to maturity (the discount rate applied to the face value) and the time until maturity.
Zero-coupon bond
A zero-coupon bond with a negative yield would be priced at?
Premium
The investor receives a cash interest payment each period in addition to the face value at maturity.
Coupon bond
For a fixed coupon bond the bond’s coupon rate is a percentage of the face value and determines the amount of?
The interest payments
Some bonds exist that have no maturity date. We refer to these as.
Perpetual bonds or perpetuities
What’s the PV of a perpetuity?
Perpetuity equals payment divided by r
What’s the difference between amortizing bond and fixed coupon bond?
The difference between an amortizing bond and a fixed-coupon bond is that for an amortizing bond, each payment includes some portion of the principal.
With a fixed-coupon bond, the entire principal is paid to the investor on the maturity date.
A bond that pays a level amount each period, including its maturity period, each payment includes some portion of the principal.
Amortizing bond
Amortizing bonds are an example of an?
Annuity bonds
When the coupon percentage is the same as the yield to maturity percentage, what do you get?
Par bond (Present value equals future value)
As with fixed-income securities, we value equity securities such as common and preferred stock as the?
Present value of their future cash flows
The key differences are that equity securities do not mature, and their cash flows may change over time
For a fixed-coupon bond if the coupon is higher than yield then it will trade at?
Premium
For a fixed-coupon bond if the coupon is lower than yield then it will trade at?
Discount
A stock that pays a fixed dividend that is stated as a percentage of its par value (similar to the face value of a bond) and assumed to be paid in perpetuity.
Preferred stock
Because we can consider a preferred stock’s fixed stream of dividends to be infinite, we can use what formula to determine its value?
Perpetuity formula which is (Perpetuity equals payments or cash flows divided by r)
Since we are valuing an equity security the formula is (Perpetuity equals dividend per period divided by required rate of return)
A stock that is residual claim to a company’s assets after it satisfies all other claims.
Common stock
Common stock typically does not promise a fixed dividend payment. Instead, the company’s management decides whether and when to pay common dividends.
Because the future cash flows are uncertain, we must use models to estimate the value of common stock such as?
- dividend discount models (DDMs) for constant growth rate.
- multistage DDM for a changing growth rate of dividends.
What is the relationship between prices and yields?
Inverse
How do you imply equity returns?
Recall constant growth model which is (dividend period divided by cost of equity minus growth rate)
In order to find equity return, rearrange to (dividend period divided by yield plus growth rate)
How do you imply growth rate for equity?
Recall constant growth model which is (dividend period divided by cost of equity minus growth rate)
In order to find growth rate, rearrange to dividend period divided by yield minus cost of equity)
“Law of one price,” which says that if two sets of future cash flows are identical under all conditions, they will have the same price today (or if they don’t, investors will quickly buy the lower-priced one and sell the higher-priced one, which will drive their prices together).
No-arbitrage principle
Forward interest rates, forward exchange rates, and option pricing all use the principle that equivalent cash flows must have the same value
No-arbitrage valuation
A borrowing or lending rate that starts at some future date, for a set time period
Forward interest rate
A borrowing or lending rate that starts today, for a set time period
Spot interest rate
Define these forward interest rate examples
1y1y
2y1y
3y2y
Starts in one year, for a one-year rate
Starts in 2 years, for a one-year rate
Starts in 3 years, for a two-year rate
The no arbitrage forward exchange rate reflects the difference in interest rates between countries
Interest rate parity
The right, but not the obligation, to buy or sell an asset on a future date for a specified price.
Option
Right to sell an asset
Put option
Right to buy an asset
Call option
