stocks and bond markets Flashcards
what is the stock market
financial marketplace where buying, selling and issuing shares of publicly held companies take place
- provides platform for companies to raise capital by selling ownership stakes to investors
what are shares/ stocks
represents ownership in a company
- when u own it, u become a shareholder and have a claim on a portion of the company’s assets and earnings
what are listed companies
companies that offer their shares for public trading are listed on a stock exchange
what are primary markets
a financial market in which new issues of shares are sold to initial buyers
- this facilitates new financing to corporations
what is a secondary market
one in which securities that have been previously issued are resold
- most of the trading of securities take place here
what 2 important functions do secondary markets serve
- they make financial securities more liquid - makes securities more desirable to investors = easier to sell in primary market
- set the price of the securities the firms sell in the primary market
what are stockbrokers
investors sell and buy stocks through stockbrokers - act as intermediaries
what are stock market indices
provide a snapshot of the overall market or specific sectors
what are bull and bear markets
bull market
- period of rising stock prices and optimism
bear market
- period of falling prices and pessimism
what is market capitalisation
the total value of a company’s outstanding shares of stock
- multiply the share price by the number of outstanding shares
what are dividends
some companies distribute a portion of their profits to shareholders in the form of dividends
- such payments are one way investors can receive returns on their investment
what is dividend yield
financial ratio that represents the annual dividend income an investor can expect to receive from an investment ( expressed as a percentage of the investments current market price)
- annual dividend/ current share price
- higher this - higher income relative to the investments current market price
- high this may also be because of declining stock price = financial distress
what is price to earnings ratio
valuation metric that compares a company’s current stock price to its per-share earnings
- provides insights into how much investors are willing to pay for each dollar of a company’s earnings
- current share price/ earnings per share
- high P/E = investors expect higher future earnings growth - willing to pay a premium =overvaluation
how do we determine the value of a company and its shares
- market value - price of the share x the number of shares issued
- look at the company’s balance sheet and identify the total value of the company’s assets and minus the liabilities
- tells us the book value of the company’s equity
what is equity
what is owned by the shareholders and essentially includes all the issued shares plus all the profits made by the company and not returned to shareholders but, instead, reinvested back into the company
why is the book value of a company’s assets considerably lower than the market value
the book value = a historical measure of the firm’s asset value after paying off debts
the market value = forwards looking measure of the firms ability to generate earnings from its existing assets and future investments
how do we determine the value of an asset
sum of the present value of all cash flows generated by an asset
what is the problem with the dividend discount model
impractical to use - we dk the all the dividends paid by a stock until infinity
- we may only be able to estimate the next one or two dividends based on analysis of the company
- cant use the model for valuing a stock without making an assumption about how dividends evolve over time
what are the 3 assi,pitons that are commonly used to make the dividend discount model usable
- dividends are constant - no growth over time
- dividends grow at a constant rate
- dividends grow at different rates over different periods of time
what are bonds
debt securities that are traded in markets issued by companies and governments to raise money from investors today in exchange for a promised future payment
- terms of the bond : bond certificate - indicates amounts and dates of all payments to be made
- payments of the bond are made until a final repayment date = maturity date
- they have maturity of greater than one year
- provide source of long-term finance
- referred to as fixed interest as the cash flows they deliver to an investor and the dates the cash flows are paid tend to be known in advance
what is par value
the nominal value of the bond that is repaid to the bondholders at maturity
- oso known as the principal or face value
what is a coupon
periodic payment of interest on a bond
- general paid semi-annually
- coupon rate is the coupon expressed as a percentage of the par value
what is maturity date
the specified date on which the par value of the bond must be repaid
what are the different type of bonds
- zero coupon bond - bond that pays no interest (coupon)
- the only payment is par value
- compensated for the time value of your money : sold at a discount to par value so an investor will receive return in the form of capital appreciation - coupon bond
- bond that pays both coupons and par value
what is yield to maturity on the bond
the return required by the bond investors to compensate for the risk of investing in the bond
it is a measure of the total return on the bond if it is held to maturity and captures both the income (interest) and capital gain/loss on the bond with interest reinvested
- sets the present value of the promised bond payments equal to the current market price of the bond
bond investors typically compare YTM of different bonds
- bonds with similar risk/ maturity should have similar YTM
- for a bond, as coupon, par value and maturity are fixed when issued, the only element of the bond that can change is its price = YTM
- if a bond has low YTM compared to similar bonds = price of the bond is likely to fall = rise in YTM
when is a bond said to be trading at a premium and at a discount
- premium
- when the market price of the bond is higher than its face value , the YTM will be lower than the coupon rate - discount
- when the market price is lower than the face value, the YTM will be higher than the coupon rate
what are the 2 meanings duration have in relation to bonds
- macaulay duration measures the weighted average time it takes for the cash flows from a bond to repay its initial investment
- considers the time of arrival of all cash flows and the maturity of the bond
- it is the weighted average of the maturity of the cash payments, where the weights are the relative present values of each cash flow - modified duration expresses the interest sensitivity of a bond’s value
why is the macaulay duration lower than the maturity
the macaulay duration allows for the possibility that the average life of a bond to differ from their respective maturities
- the duration is lower because the bond pays some cash flows prior to maturity
- it is only for zero coupon bonds with no intermediate cash flows that the macaulay duration equals its maturity
what are 3 important features of macaulay duration
- it increases with the maturity of a bond
- it decreases as the market interest rate increases; higher rates discount later cash flows more heavily and the weights of those later cash flows decline when compared to earlier cash flows
- it decreases as the coupon interest rate increases; the larger the coupons, the more quickly cash flows are received by investors and the higher the weights of those cash flows
what are the 2 types of payments bonds typically make
- principal/ face value
-paid at maturity - coupons - some bonds promise additional payments
- paid periodically until maturity date of the bond
what is the yield to maturity of a zero-coupon bond
the price of such bond is the cost of the bond
- rate of return is the discount rate that makes the present value of the future cash flow = the cost of the bond
what are the 2 sources that the return on a coupon bond comes from
- any difference between the purchase price and the principal value
- its periodic coupon payment
- before we compute the YTM, need to know all the cash flows, including the coupon interest payments and when they are paid
how does interest rate affect different bonds
even bonds with the same maturity will differ in interest rate sensitivity if their coupon rates are different
- bonds with higher coupon rates - cuz they pay higher cash flows up front - are less sensitive to interest rate changes
- bonds with smaller coupon payments - more sensitive, its coupons are smaller relative to its par value = larger fraction of its cash flows are received later
- longer term to maturity = increased effect on interest rate risk
- higher coupon rate = decreased effect on interest rate risk
what is credit risk of the bond
it is the risk of default = the bonds cash flows are not known with certainty
with corporate bonds, the bond issuer may default - it may not pay back the full amount promised in the bond prospectus
to compensate for the risk , investors demand a higher interest rate
what can we deduce, from the dividend discount model, about the factors which affect the value of a stock
the value of the stock is determined by
- the dividends paid by the company to infinity (assuming the company has infinite life)
note: due to discounting , the contributions of a future dividend to the price declines over time so that near dividends have the greatest influence - required yield on the stock
- captures the risk of the stock to the investor
what are the main challenges with valuing a stock
- estimating future dividends - have to make some assumptions about the future evolution of dividends which may not be realistic
2.determining a suitable discount rate
how realistic are the 3 assumptions for the evolution of dividends
- dividends are unlikely to be constant
- the assumption is not very realistic as in this case the purchasing power of those dividends would reduce over time due to inflation - constant growth rate is more realistic as dividends are likely to grow over time as earnings of the company grows
- not realistic for all companies - dividend growth at different rates for different periods may work better for start ups with rapid growth early on which settles into a slower growth as the company matures
what determines stock prices
the firms ability to generate cash flows
what aspects of cash flows affect the asset value and stock prices
- amount of the cash flow expected by shareholders
- timing of the cash flow stream
riskiness of the cash flow stream
all 3 determine the stock’s intrinsic value
what is capital outlays
money that the business or government allocates to buy or maintain long-term assets
what are the different types of loans
- pure discount loans
- no interim interest; entire original principal and accumulated interest are paid at maturity
- loan is issued at discount - intimated funds received are less than the total amount paid at maturity - interest only loans
- interest paid throughout the loan, principal entirely paid at maturity - loans with fixed principal payments
- interest and fixed amount of principal paid throughout the loan period - amortized loans
- interest and a portion of the principal paid throughout the loan period
