Sec.3 - Ch.6: Bond & Stock Valuation Flashcards
What is Bond Duration?
- The weighted average maturity of the bond’s cash flow on a present value basis
- They are a good measure of how risky a bond is because it measures their sensitivity to interest rate changes
- Allows investors to compare price volatility of bonds with equal coupons but different terms
How is Duration related to Current Yield?
It is INVERSELY related to yield to maturity
- Market interest rates increase, duration decreases
How is Duration related to Annual Coupon
It is INVERSELY related to coupon rate
- increase in coupon rate, decrease in duration
How is Duration related to Years to Maturity?
They are positively related (time is on top)
- Maturity increases, Duration increases
What duration lengths do risk adverse investors prefer?
Short Durations, only if they anticipate interest rates will rise
What duration lengths do aggressive investors prefer?
Long durations, only when they anticipate interest rates will decline
How do you immunize a bond portfolio?
The portfolio will be immunized if the duration of the overall portfolio is equal to the preselected time horizon
- This is considered a passive investment strategy
When matching the duration of a bond/bond portfolio to the client’s time horizon, what risks are offset?
Interest rate and reinvestment rate risk
What is the duration of a zero coupon bond?
zero coupon bonds have durations equal to their maturities
- Since they have no coupons, their prices fluctuate more than those of coupon bonds with the same maturities
What are advantages of zero coupon bonds?
- They are attractive and conservative investments for retirement plans (produce phantom income, IRA’s avoid the tax on that)
- They are suitable and conservative investments for gifts to dependent children under age 23 (kiddie tax)
What type of bonds should a person buy if interest rates are expected to rise? Think UPS
Buy higher coupon bonds with short maturities to shorten duration (interest rates UP, Shorten duration)
What type of bonds should a person buy if interest rates are expected to fall? Think FALLEN
Buy low coupon bonds with long maturities to lengthen duration (interest rates, FALl, LENgthen duration)
When the coupon is smaller, the relative price fluctuation is _____
When the coupon is smaller, the relative price fluctuation is greater
When the term to maturity is longer, the relative price fluctuation is ______
When the term to maturity is longer, the relative price fluctuation is greater
When the market interest rate is lower, the relative price fluctuation is ______
When the market interest rate is lower, the relative price fluctuation is greater
Dividend Discount Model: If the market lowers the required rate of return (higher dividends) for a stock, the value of the stock will _____
Rise
Dividend Discount Model: If the market increases the required rate of return (lower dividends) for a stock, the value of the stock will _____
Fall
What happens to the investor if the intrinsic value is lower than the market value?
The investor will earn a lower rate of return than he requires
Dividend Discount Model Shortcut for accelerating/decelerating growth rates: What do you do when the 1st growth rate is lower than the 2nd growth rate?
Choose the next lowest number in the answer
Dividend Discount Model Shortcut for accelerating/decelerating growth rates: What do you do when the 1st growth rate is higher than the 2nd growth rate?
Choose the next highest number in the answer
How do you calculate the current market price using the P/E ratio?
Current Market Price = Earnings * P/E ratio
What is the Return on Equity equation?
ROE = Earnings available for common (EPS) / Common Equity (net worth or book value)
What is the dividend payout ratio equation?
Dividend Payout Ratio = Common dividends paid / Earnings available for common (EPS)
How do you calculate EPS?
EPS = ROE (per share) * Book Value or Net Worth (per share)
T/F Utility stocks typically have high dividend payout ratios
True
What is not a factor in the Dividend Discount Model?
Gross Earnings of the Company
- Beta, Dividends actually paid, and the risk-free return are all utilized at some point to solve this
