Finance 301 Final Exam summary of the important things Alpha of a portfolio measure of how a stock performed relative to its expected performance stocks that perform worse than their expected return will have a negative alpha Efficient Markets stocks stock prices respond immediately to publicly available news and relevant news Weak form market efficiency stock prices reflect the information contained in the history of past stock prices and trading volume Strong form market efficiency stock prices reflect all information past public private including private information Random Walk Hypothesis stock prices are random cannot be predicted solely on the basis of past movements react immediately to news price changes are random Reinvestment Risk income earned from a bond s coupon payment will earn a different rate of return Interest Rate Risk changes in market rates will affect the value of a bond longer the maturity the higher the interest rate risk of that bond lower the coupon rate the higher the interest rate risk of that bond Risk higher the standard deviation of returns the higher the expected returns risk and return have a direct relationship Bonds issue repayment of principal at their maturity debt instruments Systematic Risk cannot be diversified away market risk Unsystematic Risk can be diversified away firm specific risk Upward Sloping Yield Curve require higher returns for longer maturity treasuries Downward Sloping Yield Curve expect interest rates to decline Beta measure of market related systematic risk of an asset Alpha measure of the difference between the observed and expected return of an asset Fama French Study stocks with small market caps outperform stocks with large market caps stocks with low P E ratios outperform stocks with high P E ratios Pure Expectations Hypothesis yield curve represents a series of expected future short term interest rates Liquidity Premium Hypothesis investors would prefer to hold short term securities and so are paid higher interest rates as a premium for holding long term securities Fundamental Analysis studying financial statements Technical Analysis charting historic stock price movements and trading volumes argues that prices are driven by psychology and emotions of the crowd Callable Bonds vs Non Callable Bonds callable bonds usually have higher yields Callable Bond attractive to the issuer because it allows the issuer to prepay outstanding debt if new debt can be issued at lower rates Most likely to call their bonds issuer s credit rating improves Least likely to call their bonds issuer s credit rating deteriorates Par Bond coupon rate is equal to the market yield A bond that is selling at a discount requires that the yield must be greater than the coupon rate Premium Bond coupon rate is greater than the market yield Float Rate Bonds issuer retains the interest rate risk Collateral Risk not associated with investing in fixed income securities Risk associated with investing in fixed income securities interest rate risk default risk reinvestment risk prepayment risk Least amount of risk reduction pick one with the highest correlation Most amount of risk reduction pick one with the lowest correlation Shortest Duration want the highest coupon rate Longest Duration want the lowest coupon rate Bond Prices move inversely to changes in interest rates Value of your bond if the Federal Reserve decides to lower interest rates the value of your bond increases if the Federal Reserve decides to raise interest rates the value of your bond decreases With diversification an investor can reduce unsystematic risk With hedging an investor fixes the sale price of an asset Derivative Securities derivative markets often more efficient than the spot markets liquidity is often greater in the derivative markets than in the spot markets Stock Valuation profits and stock values have a direct relationship interest rates and stock values have an inverse relationship Sell stock when the price is greater than the value stock is currently overvalued Buy stock when the price is less than the value stock is currently undervalued Glass Steagal Act of 1933 Created by FDIC Forced the separation of traditional commercial banking and investment banking Dodd Frank Bill Avoided situations that were too big to fail Efficient Frontier Used to achieve highest possible return for a given risk Use call option when interest rates drop Duration Measure of price volatility Duration change in P P Change in Y Coupon Duration Maturity Volatility Beta Volatility Interest Rate Risk Changes in market interest rates will negatively impact the value of the bond Market Price Market Interest Rates Spread to Treasuries How likely a corporate bond is to default compared to a treasury bond Spread To Treasuries Yield on Corp Bond Yield on Treasury bond with Same Maturity Equations you will need to memorize Beta stock return market return Market Risk Premium Avg return rate T Bill rate S P 500 T Bill Company Risk Premium Beta x market avg T bill CAPM capital asset pricing model Expected Return T Bills Beta x market avg T bill Alpha actual return expected return to get expected in order to solve Alpha T Bills Beta x market avg T bill Alpha with prices end price beg price div beg price Return Received over year selling price buying price dividends buying price Real Rate of Return nominal interest inflation Level of Inflation nominal interest real treasury yield WACC equity x cost of equity debt x after tax rate x cost of debt Taxable Equivalent Bond interest rate yield 1 tax bracket Value of Perpetuity payments interest rates annual cash flows discount rate Stockholder s Return div change in price beg price change in price end price beginning price Time Value Strike Market Intrinsic Value Current Strike