Test 2 Flashcards
Compound interest
to compute the future value of an amount we push forward the current amount by ADDING interest for each period in which the money can earn interest in the future
Time Value of Money
money at different points in time are not the same
Implications of time value of money
Dollar amounts from different time periods should never be compared; rather, amounts should be compared only when they are stated in dollars at the same point in time.
TVM concepts provide the principles and computations used to revalue cash payoffs from different time periods so they are stated in dollars of the same time period.
The most important concept in finance used in nearly every financial decision
Expected return
the weighted average of all the possible returns, weighted by the probability that each return will occur
Risk
the chance that some unfavorable event will occur
Risk vs Diversification
Diversification reduces risk
Specific risk
Non-systematic risk–
risk that affects only a specific firm, which can be eliminated through diversification (labor strikes)
Market risk
Systematic risk–a risk that affects all firms, which cannot be eliminated through diversification (tax rate changes, war)
How is total risk different from systematic risk (when are the two equal to each other?)
Suppose that in the coming year, you expect Target stock to have a standard deviation of 30% and a beta of 1.32, and Starbucks’s stock to have a standard deviation of 41% and a beta of 0.6. Which stock carries more total risk? Which has more systematic risk?
Total risk
measured as standard deviation or coefficient variation of the portfolio return
What is the beta of a portfolio?
the risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio’s market risk
What does the beta measure?
Beta coefficient measures a stock’s market risk, and shows a stock’s volatility relative to the market. It indicates how risky a stock is if the stock is held in a well diversified portfolio
What is the beta for the market and the risk-free asset?
market portfolio beta=1
risk-free asset beta=0
CAPM model
a theoretical model in finance that finds the risk premium for an equity security
What does CAPM measure?
Expected return for an investment, considering its risk. Determines the required rate of return or cost of equity for a security based on its beta, the risk-free rate, and the market risk premium
Who issues treasury bonds?
US Government
Who issues corporate bonds?
Companies
Who issues municipal bonds?
State or local governments
Who issues foreign bonds?
A foreign entity
Par value
the stated face value of the bond, which is paid to the bondholder at maturity
Characteristics on bonds
Par value
Coupon interest rate
Maturity
Indenture
Call provisions
Sinking funds
Callable bonds and convertible bonds
Coupon interest rate
Stated interest rate (generally fixed) paid by the issuer.
Zero coupon bonds (zeros)
Maturity
The length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond
Indenture
Formal contract, also known as a trust indenture, that outlines the terms and conditions of a bond issue–restrictive covenant
Call provisions
A bond contract (bond indenture) gives the issuer the right, but not the obligation, to redeem the bond before its stated maturity date
Sinking funds
Call for redemption by annual lottery, buy bonds on the open market
Callable bonds
Bonds that can be redeemed or paid off by the issuer prior to the bonds’ maturity date
Convertible bonds
A type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value
Types of corporate bonds
Debentures
Subordinated Debentures
Mortgage Bonds
Junk Bonds
Bond ratings
Debentures
an unsecured loan certificate issued by a company, backed by general credit rather than by specified assets
Subordinated Debentures
an unsecured bond or loan that ranks below other, more senior debt in terms of repayment priority
Mortgage bonds
type of bond secured by a pool of mortgages on real estate, typically residential property
Junk bonds
a high-yield, high-risk security, typically issued by a company seeking to raise capital quickly in order to finance a takeover
Bond ratings
a letter grade assigned by independent agencies to reflect a bond issuer’s creditworthiness–an indication of its default risk
Valuation of bonds
Intrinsic/economic value
YTM for bonds
Bonds traded
Intrinsic value
estimate of a stock’s “true” value based on accurate risk and return data
Economic value
The theoretical fair value of a bond is calculated by discounting the future value of its coupon payments by an appropriate discount rate
Yield to Maturity (YTM) for bonds
YTM refers to the average rate of return the investor will earn if the bond is held to maturity. YTM is also known as the bondholder’s expected rate of return.
Where are bonds traded?
some bonds are traded publicly through exchanges, most trade over-the-counter between large broker-dealers acting on their clients’ or their own behalf
Common stock features
Par value
Dividends
Voting rights
Maturity
Priority to assets and earning
Preemptive right
Maturity
Common stock properties
A certificate that indicates ownership in a corporation.
Common stockholders are the true owners of the firm.
Types of common stock
Classified stock: common stock that is given a special designation, such as Class A, Class B, etc. to meet special needs of the company (voting and non-voting)
Types of stock market transactions
order types (like market, limit, and stop orders) and trading strategies (like day trading, swing trading, and position trading)
Types of markets common stock is traded in
Public and private markets, with the most common being the secondary market where trading occurs on exchanges like the New York Stock Exchange (NYSE) and Nasdaq
Valuation of common stock
to value stock, we use the same approach
described for valuing bonds—find the present value of all the cash flows expected to be
received from the stock in the future
Multi-period model with constant growth
a stock whose dividends are expected to grow forever at a constant rate, g
Characteristics of preferred stock
Preferred dividends
Par value
Cumulative dividends
Voting rights
No specific maturity date
Convertability
