FIN4504 EXAM II Study Guide Exam II Thursday 2 26 18 Multiple choice 2 blank space problems Bond provisions o Call provision some corporate bonds are issued with call provisions allowing the issuer to repurchase the bond at a specified call price before the maturity date If a company issues a bond with a high coupon rate when market interest rates are high and interest rates later fall the firm might like to retire the high coupon debt and issue new bonds at a lower coupon rate to reduce interest payments The callable bond gives the issuer the option to extend or retire the bond at the call date o Convertible provision convertible bonds give bondholders an option to exchange each bond for a specified number of shares of common stock in the firm The conversion ratio gives the number of shares for which each bond may be exchanged o Put provision putable bonds a bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years The putable bond gives the bondholder the option to extend or retire the bond at some date If the bond s coupon rate exceeds current market yields the bondholder will choose to extend the bond s life If the bond s coupon rate is too low it will be optimal not to extend o Floating rate bonds reset according to a specified market rate bonds with coupon rates periodically The major risk involved in floaters has to do with changing credit conditions Operating performance items to improve bond ratings o Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer s financial ratios Coverage ratios ratios of company earnings to fixed cost Low or falling coverage ratios signal possible cash flow difficulties measure the firm s ability to pay bills Leverage ratios coming due with its most liquid assets assets or equity Profitability ratios measures of rates of return on Indicators of the firm s overall performance Return on assets and return on equity are the most popular o Firms with higher ROA and ROE should be better able to raise money in security markets because they offer prospects for better returns on the firm s investments this is the ratio of total cash Cash flow to debt ratio flow to outstanding debt Discount premium aspects to bonds o Discount Bond bond selling below par value Yield to maturity exceeds coupon rate Bond price will increase to par over its maturity o Premium Bond bond selling above par value Coupon rate exceeds yield to maturity Bond price will decline to par over its maturity 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 current yield on the bond will be above the promised yield There must be a capital loss on the premium bond over the year to get the overall yield down to the promised YTM Zero coupon bond benefits issues o A bond paying no coupons that sells at a discount and provides only a payment of par value at maturity o The bond has a coupon rate of zero o These bonds are issued at prices considerably below par value and the investor s return comes solely from the difference between issue price and the payment of par value at maturity o See Ch 10 Slide 32 Calculate covariance o Portfolio risk depends on the covariance between returns of the assets in the portfolio o The covariance is calculated in a manner similar to the variance Instead of multiplying the difference of an asset return from its expected value by itself i e squaring it we multiply it by the deviation of the other asset return from its expectation o For each scenario we multiply the deviation of the stock fund return from its mean by the deviation of the bond fund See Equation 6 1 pg 153 in book See Spreadsheet 6 4 pg 153 in book o The problem with covariance covariance does not tell us the intensity of the comovement of the stock returns only the direction An easier statistic to interpret is the correlation coefficient which is the covariance divided by the product of the standard deviations of the returns on each fund See Equation 6 2 pg 154 in book o If covariance is positive the stock and bond portfolios move in the same direction positively correlated o If covariance is negative portfolios move in different directions negatively correlated o See Ch 6 Slide 8 18 19 20 72 73 problem 3 75 Aspects to asset backed securities o Income from specified assets is used to service the bond Walt Disney had issued bonds with coupon rates tied to the financial performance of several of his films o More conventional asset backed securities are mortgage backed securities or securities backed by auto or credit card loans Calculate actual excess return o Excess Return the rate of return in excess of the risk free rate Ri ri rf Ri excess return ri rate of return rf risk free rate o Alpha a stock s expected return beyond that indicated by the market index its expected excess return when the market s excess return is zero A positive alpha implies the security is undervalued Positive alpha is good negative alpha is bad The difference between the return required for the risk level CAPM and the actual return is alpha o See Ch 6 Slide 61 Ch 7 Slide 36 53 54 Calculate beta o Beta factor the sensitivity of a security s returns to the market The security s beta is the typical response of that particular stock s excess return to changes in the market index s excess return A value greater than 1 would indicate a stock with greater sensitivity to the economy than the average stock o Get beta of a portfolio by the sum of each weight times the o Adjusted Betas beta of the asset the empirical finding that betas different from 1 tend to move toward 1 over time calculated betas are adjusted to account for Adjusted B 2 3 calculated B 1 3 1 o See Ch 6 Slide 61 74 80 Ch 7 Slide 17 18 36 43 44 45 Calculate weighted return o Weighted return W1r1 W2r2 W1 of money invested in stock 1 W2 of money invested in stock 2 R1 expected return on stock 1 R2 expected return of stock 2 o See Ch 6 Slide 5 70 What does beta imply o Beta measures systematic risk with respect to an individual security o Beta is the relevant measure of risk of a particular asset with respect to the market portfolio o Any beta above 1 should result in a return above the market return more volatile than the market A beta of 1 indicates that the security s price will move with the market A beta of less than 1 means that the security will be less volatile