FIN 4504 Exam 2 Review 18 Multiple Choice Questions 2 Short Answers Professor Suggested these will be the short answers in class 1 Bond Provisions a The call provision is in the favor of the bond issuer the issuer is likely to call in the bond when interest rates have fallen The bond will be redeemed at a price over par but the investor will be left with reinvesting in a lower interest rate environment The firm is not going to call the bond unless its market value would have been above the call price Most bonds are callable after an initial call protection period of 3 to 5 years The quid pro quo is that bond issuers will have to pay a slightly higher yield rate if the bond is callable 2 Operating performance items to improve a Bond rating chapter 10 page 314 a Coverage ratios ratios of companies earning to fixed costs Low or falling coverage ratios signal possible cash flow difficulties b Leverage ratio debt to equity ratio Too high of a leverage ratio shows a company has significant debt and might have difficulty satisfying the obligations on its bonds c Liquidity ratios The two common liquidity ratios are the current ratio current assets current liabilities and the quick ratio current assets excluding inventories current liabilities These ratios measure the firm s ability to pay bills coming due with its most liquid assets d Profitability ratios Measures of rates of return on assets or equity Profitability ratios are indicators of a firm s overall performance The return on assets earnings before interest and taxes divided by total assets or return on equity net income equity are the most popular of these measures Firms with higher return on assets or equity should be better able to raise money in security markets because they offer prospects for better returns on the firm s investments e Cash flow to debt This is the ratio of total cash flow to outstanding debt 3 Discount Premium aspects to bonds a Premium Bond i Coupon rate exceeds yield to maturity ii Bond price will decline to par over its maturity b Discount Bond i Yield to maturity exceeds coupon rate ii Bond price will increase to par over its maturity c A premium bond is priced above par because the coupon rate is too high relative to what the bond is supposed to be yielding The only way to get the expected yield down to the ytm is to have the bond priced above par In this case the current yield on the bond will be above the promised yield Hence there must be a capital loss on the premium bond over the year to get the overall yield down to the promised ytm 4 Zero coupon bond benefit issues a Zero coupon bonds are bonds that do not make any interest payments which investment professionals often refer to as the coupon until maturity If you need a specific amount of income on a specific date in the future they may be the perfect choice b c Zero coupon bonds are also appealing for investors who wish to pass wealth on to their heirs but are concerned about income or gift taxes If a zero coupon bond is purchased for 1 000 and given away as a gift the gift giver will have used only 1 000 of his or her yearly gift tax exclusion The recipient on the other hand will receive significantly more than 1 000 when the bond matures d Zero coupon bonds come in many varieties Two of the most common include the issuer and the tax status Zero coupon bonds may be issued by federal state or local governments or by corporations e The lack of coupon payments on zero coupon bonds means their worth is based solely on their current price compared to their face value Thus prices tend to rise faster than the prices of traditional bonds when interest rates are falling and vice versa The locked in reinvestment rate also makes them more attractive when interest rates fall 5 Calculate covariance a 6 Aspect to asset backed securities a Asset Backed Securities A financial security backed by a loan lease or receivables against assets other than real estate and mortgage backed securities For investors asset backed securities are an alternative to investing in corporate debt b An ABS is essentially the same thing as a mortgage backed security except that the securities backing it are assets such as loans leases credit card debt a company s receivables royalties and so on and not mortgage based securities 7 Calculate actual excess return a Ri E Ri iM ei b Ri Actual excess return ri rf c E Ri expected excess return d The excess return on an asset above the risk free rate is the expected excess holding period return beta which is the sensitivity of this asset to any macroeconomic surprise e which is the impact of any unanticipated firm specific events 8 Calculate beta a 9 Calculate weighted return a E rp W1 r1 W2 r2 b W1 Proportion of funds in Security 1 c W2 Proportion of funds in Security 2 d r1 Expected return on Security 1 e r2 Expected return on Security 2 10 What Beta explains a Beta The sensitivity of a security s returns to the market factor b Beta measures a stock s comparative sensitivity to macroeconomic news c A value greater than 1 would indicate a stock with greater sensitivity to the economy than the average stock These are known as cyclical stocks d Betas less than 1 indicate below average sensitivity and therefore are known as defensive stocks 11 Calculate CAPM a 12 CAPM assumptions 1 E Ri the expected return on the capital asset 2 Rf the risk free rate of interest such as a U S Treasury bond 3 i the beta of security or portfolio i 4 E Rm the expected return of the market Individual investors are price takers Investments are limited to traded financial assets Information is costless and available to all investors Investors are rational mean variance optimizers a b Single period investment horizon c d No taxes and no transaction costs e f g Homogeneous expectations h Think of a world where individuals are all very similar except their initial wealth and their level of risk aversion Price Takers means that individuals do not effect prices Big assumption An individual s behavior does not effect price Rational mean variance optimizers means that all investors attempt to construct efficient frontier portfolios like we discussed in chapter 7 Homogeneous expectations means that if two investors examine the same investment opportunity they will have identical beliefs about the expected returns variance of returns and correlations with other investments The result will be that all investors will find that the Market portfolio is on the efficient