Ch 6 Finance Exam 2 Terms 1 Risk potential variability in future cash flows 2 Standard deviation a statistical measure of the spread of a probability distribution calculated by squaring the difference between each outcome and its expected value weighing each value by its probability summing over all possible outcomes and taking the square root of the sum 3 Company Unique Risk the risk related to an investment return that can be eliminated through diversification Unsystematic risk is the result of factors that are unique to the particular firm Also called company unique risk or diversifiable risk 4 Market Risk 1 the risk related to an investment return that cannot be eliminated through diversification Systematic risk results from factors that affect all stocks Also called market risk or nondiversifiable risk 2 The risk of a project from the viewpoint of a well diversified shareholder This measure takes into account that some of the project s risk will be diversified away as the project is combined with the firm s other projects and in addition some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolios 5 Diversification owning many different stocks in your portfolio 6 Holding period returns historical or realized rate of return the rate of return earned on an investment which equals the dollar gain divided by the amount invested 7 Beta the relationship between an investment s returns and the market s returns This is a measure of the investment s nondiversifiable risk 8 Portfolio beta the relationship between a portfolio s returns and the market s returns It is a measure of the portfolio s nondiversifiable risk 9 Asset allocation identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of those assets within the portfolio 10 Required rate of return minimum rate of return necessary to attract an investor to purchase or hold a security 11 Risk premium the additional return expected from assuming risk 12 Capital Asset Pricing Model CAPM an equation stating that the expected rate of return on a project is a function of 1 the risk free rate 2 the investment s systematic risk and 3 the expected risk premium for the market portfolio of all risky securities 13 Security market line the return line that reflects the attitudes of investors regarding the minimum acceptable return for a given level of systematic risk associated with a security Ch 7 1 Bond a long term 10 year or more promissory note issued by the borrower promising to pay the owner of the security a predetermined fixed amount of interest each year 2 Debenture any unsecured long term debt 3 Subordinated debenture a debenture that is subordinated to other debentures in terms of its payments in case of insolvency 4 Mortgage bond a bond secured by a lien on real property 5 Eurobond a bond issued in a country different from the one in which the currency of the bond is denominated for example a bond issued in Europe or Asia by an American company that pays interest and principal to the lender in U S dollars 6 Zero coupon bond a bond issued at a substantial discount from its 1 000 face value and that pays little or no interest 7 Junk bond any bond rated BB or below 8 Convertible bond a debt security that can be converted into a firm s stock at a prespecified 9 Par value on the face of a bond the stated amount that the firm is to repay upon the maturity 10 Coupon interest rate the interest rate contractually owed on a bond as a percent of its par price date value 11 Maturity the length of time until the bond issuer returns the par value to the bondholder and terminates the bond 12 Call provision a provision that entitles the corporation to repurchase its preferred stock from investors at stated prices over specified periods 13 Indenture the legal agreement between the firm issuing bonds and the bond trustee who represents the bondholders providing the specific terms of the loan agreement 14 Bond ratings bonds that are called BB or higher 15 Book value 1 the value of an asset as shown on a firm s balance sheet It represents the historical cost of the asset rather than its current market value or replacement cost 2 The depreciated value of a company s assets original cost less accumulated depreciation less outstanding liabilities 16 Liquidation value the dollar sum that could be realized if an asset were sold 17 Market value the value observed in the marketplace 18 Intrinsic value economic value the present value of an asset s expected future cash flows This value is the amount an investor considers to be fair value given the amount timing and riskiness of future cash flows 19 Value of an Asset how much an asset is worth 20 Yield to Maturity the rate of return a bondholder will receive if the bond is held to maturity 21 Current yield the ratio of a bond s annual interest payment to its market price 22 3 bond value relationships 1 The value of a bond is inversely related to changes in the investor s present required rate of return In other words as interest rates increase decrease the value of the bond decreases increases 2 The market value of a bond will be less than the par value if the required rate of return of investors is above the coupon interest rate but it will be valued above par value if the required rate of return of investors is below the coupon interest rate 3 Long term bonds have greater interest rate risk than do short term bonds 23 Interest rate risk the variability in a bond s value created by changing interest rates 24 Discount bond a bond that sells at a discount or below par value 25 Premium bond a bond that is selling above its par value