43 Cards in this Set
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Initial Public Offerings (IPOs)
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Stock issues from firms initially going public, or allowing their equity shares to be publicly traded on stock markets for the first time
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Primary Markets
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Those where new securities are issued to investors; here the money from investors goes to the issuing party; initial public offerings for stocks, new issues for debt
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Secondary Markets
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Those where existing securities are bought and sold between investors –The New York Stock Exchange and the NASDAQ are two examples; We mainly focus on secondary markets
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Benefits of Secondary Markets
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Secondary markets offer benefits to both investors and issuers. Investors gain: liquidity and diversification benefits. Issuers gain: information about their securities' market value Public firms can see how investors perceive their corporate value by checking securities and secondary mar…
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Liquidity
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The ease with which an asset can be converted into cash
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Price Risk
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the risk that an asset's sale price will be lower than its purchase price
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inflation
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Inflation is the general rise of the price of a basket of goods over time –When prices decline its referred to as deflation In the US, we use the consumer price index (CPI) to track inflation and calculate its rate; CPI - a measure of the average change over time in the prices paid by urb…
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Examples of financial institutions
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def: institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds
commercial banks, thrifts, insurance companies, securities firms and investment banks, finance companies, pension funds, mutual funds
•Financial i…
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Components of an interest rate
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Ij = RIR + IP + DRPj + LRPj +SCPj + MPj
real interest rate
inflation premium
default risk premium
liquidity risk premium
special covenant premium
maturity premium
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default risk premium
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Risk that a security issuer may fail to make its promised interest and principal payments to its bondholders (or its dividend in the case of preferred stockholders)
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Inflation risk premium
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risk of the continual increase in the price level of a basket of goods and services
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Liquidity Premium
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The additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price
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Rights and Benefits of stockholders
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•As a shareholder you get one vote for each of your shares on matters such as:
–Who is elected to the board of directors
–Acquisition offers
–Executive compensation (non-binding)
–Charter amendments
These items are outlined in a firm’s proxy statement(s) (DEF 14A is the SEC name)
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Major Market Indexes and what they are composed of
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•The three major indexes in the US are:
–Dow Jones Industrial Average (DJIA or the Dow)
–Standard & Poor’s 500 Index (S&P 500)
–NASDAQ Composite Index
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Dow Jones Industrial Average (DJIA or the DOW)
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Composed of 30 stocks; very large companies, the firms in the DIJA compose roughly 30% of the value of all stocks in the US; DIJA ignores the total value of the firm, is a price-weighted average
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Standard and Poor's 500 Index (S&P 500)
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Composed of 500 firms representing 10 sectors of the economy; uses market capitalization to weigh the firms (gain on large firm will move it more than the same gain on a smaller firm)
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NASDAQ Composite
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Measures the market capitalization of all common stock traded on the NASDAQ; b/c it's high-tech focused, the NASDAQ is generally viewed as a measure of the high-tech sector and not the overall market
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Market Orders
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A market order is an order to buy or sell at the prevailing market price - the trade is completed very quickly, but you don’t know the exact price until you receive confirmation
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Limit Orders
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A limit order is an order to buy or sell at a set price - the trade is completed if the price can be met in the market. You know the exact price, but the trade might not be completed
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Bid & Ask Prices and which investors expect to receive
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Bid price - highest price at which the market maker offers to pay for the stock; Ask price - lowest price at which a market maker will sell a stock
•Difference between bid and ask prices are known as the spread
•The spreads are very small ($.01) for a large, highly traded firm
•Spreads…
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Market Capitalization and How to Calculate
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Combined value of all of the shares outstanding of a company; provides an better idea of the value of a firm versus stock price
How to calculate: Market Cap = Shares Outstanding x Price
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Constant Growth Model
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This model assumes that dividends are going to grow at a steady rate forever (growth rate is constant
and must be smaller than the discount rate)
•We can use the constant growth model to determine the expected return of a stock based on its future dividends and current price
I = D1/P0 …
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P/E Model
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P/E ratio is a valuation metric that is used to determine how expensive a stock is priced (similar to comparing different sizes of cereal based on the price per ounce)
Future Price = Future P/E Ratio x Future EPS
•Once we determine the future price, we can find its present value
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Measuring Dollar Returns
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Dollar return is the profit (or loss) made on an investment
$ Return = (Ending Value – Beginning Value) + Income
•Capital Gain = (Ending Value – Beginning Value)
•Income = Dividends paid
•Useful because: We tend to think in dollars and we spend dollars
•Limitations: Difficult to com…
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Measuring Percentage Returns
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The ratio of your dollar return to your original investment; much easier to compare different outcomes
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Average Returns
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Use over time to form expectations about the returns of investments in the future
Average return = Sum of all returns / N (N # number of returns)
The average returns that we calculate are arithmetic average returns
– Good for statistical analysis, not so great for performance measureme…
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Measuring Risk
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We measure the risk of an investment based on the standard deviation of past returns; this represents the total risk of an individual security or portfolio
– Higher standard deviations imply higher risk
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Risk/ Return Relationship
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Investors really care about the ratio of risk versus return
–Knowing returns without risk is of limited use
–Knowing risk without returns is of limited use
We measure this tradeoff with coefficient of variation (CoV)
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What risk can be eliminated through diversification?
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- ((Firm specific, unsystematic risk))
•With diversification we are able to minimize firm-specific risk and we are left with market risk
•Investing in a pool of assets reduces risk through diversification
–Process works bc asset returns are not perfectly correlated
–Diversification he…
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Efficient Portfolios
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The set of portfolios that have the maximum expected return for each level of risk. More desirable than other portfolios because they yield the highest return possible for each risk level
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Expected Returns
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•Investors care about future profits
–We estimate future profits and refer to these estimates as expectations
–Future profits are difficult to predict without knowing how the overall economy will perform
•We can estimate the returns expected under different states of the economy to get…
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Calculating Expected Returns
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Expected Return = (p1 x Return1) + (p2 x Return2) + … + (ps x Returns)
Where:
p1 = probability of Return1
s = number of returns in probability distribution
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Risk Premiums
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•We refer to the risk premium of an investment as the expected return in excess of the risk-free rate
–Extra return is the reward that investors expect to receive for taking on risk
•Riskier investments carry a higher risk premium
Required Return = Risk-free rate + Risk premium
•The…
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Risk Free Rate
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Market Risk Premium = Market Return – Risk Free Rate
•We measure the risk-free rate using the rate on T-Bills, which are risk-free short term Treasury securities
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Stock Bubbles
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When prices shoot really high and then crash
–Dotcom bubble in the late 1990s
Other assets also have bubbles: Housing bubble in 2006/2007, Tulip Mania in 1630s in Holland, Gold bubble in the 1980s
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How Stock Bubbles Relate to Behavioral Finance
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Behavior finance tries to explain bubbles under the premise that humans sometimes act irrational
–During good times, investors are too optimistic – i.e. the Dotcom bubble in 1999/2000
–During bad times, investors are too pessimistic – i.e. the Dow at 7,000 in 2009
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CAPM (Capital Asset Pricing Model)
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Pricing model used to estimate the expected return to a stock or portfolio
–Assumes that returns only reflect market risk, which is a pretty strong assumption
–The model is widely used but not very accurate
-Looks at company's beta, which measures the relative risk of the firm against …
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EMH (Efficient Market Hypothesis)
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EMH is basically concerned with the amount/type of information that is reflected in stock prices
3 forms:
–Weak-form efficiency
–Semi-strong form efficiency
–Strong form efficiency
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Weak Form Efficiency
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Weak-form indicates that current prices reflect all information derived from past trading (this includes past prices and volumes)
Under weak-form EMH you shouldn’t be able to earn abnormal returns by looking at past trading patterns
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Semi-strong Form Efficiency
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Strong form efficiency indicates that current prices reflect all info, both public and private (private info includes earnings before they are released, unannounced merger negotiations, basically anything that is non-public)
- Under strong form EMH you SHOULD NEVER be able to earn ABNORM…
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APR
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Annual Percentage Rate - interest rate when banks lend money to borrowers and earn interest; calculated on many consumer loans, mortgages and credit cards
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EAR
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Effective Annual Rate - interest rate when banks pay interest to customers who deposit money; applicable to deposit accounts; always higher than APR
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Efficient Markets
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Those where goods/asset/knickknacks are priced correctly; Requirements of an efficient market - many buyers and sellers, no prohibitively high barriers to entry, free and readily available info to all participants, low trading or transaction costs
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Study Guide: Exam 3