View
- Term
- Definition
- Both Sides
Study
- All (144)
Shortcut Show
Next
Prev
Flip
FIN 301: FINAL EXAM
Standard deviation |
-measurement of risk of an asset
-more standard deviation: more risk
|
unsystematic risk |
-firm specific risk (single company)
-can be diversified away
|
systematic risk |
-market risk: effects entire economy
-not possible to reduce systematic risk
|
CAPM assumes |
expected return on an asset depends only on systematic risk because it's possible to eliminate unsystematic risk through diversification
|
Return on an investment = |
(change in price + cash payment) / purchase price
-change in price: capital gain or loss
|
capital gain |
increase in price of a stock, bond, asset
|
capital loss |
decrease in price of stock, bond, asset
|
realized gains or losses |
-gains or losses are realized when asset is sold
|
long term gains are |
taxed at a lower rate than short term gains
|
unrealized gains or losses |
-gains or losses when you still own the asset
-if price of stock you own falls and you still own the stock, the loss is considered "unrealized" until you sell the stock
|
beta |
-measure of asset's systematic risk
|
market risk premium= |
-expected return of stock market minus risk free rate
-additional return an investor will receive if he purchases an avg risk stock (beta=1) as opposed to a treasury bill
|
asset classes in order of risk |
1. US treasury bills (4% avg return)
2. us govt bonds (5%)
3. corporate bonds (6%)
4. large company stocks
5. small company stocks
avg common stock return: 12%
|
CAPM |
theory used to price risky assets
-expected return
|
portfolio |
-specific securities owned by investor
-investors with large portfolios aren't concerned about unsystematic risk (firm specific risk)
|
well diversified portfolios are |
-identical to one another EXCEPT for their betas
-when adding additional stock to a well diversified portfolio, the stock's only effect on the portfolio is its effect on the portfolio's beta
-stock with beta greater than portfolio's beta will increase the portfolio's beta and vise versa
|
alpha= |
observed return (actual return) - expected return (capm)
|
when alpha is positive |
the security outperformed the returns expected under the CAPM benchmark
|
when alpha is negative |
security underperformed compared to the returns expected under the CAPM benchmark
|
Efficient capital markets: ECM |
prices of stocks reflect all publicly available information and stock prices adjust and react completely, correctly, and almost instantaneously to incorporate new information
-ECM is a market that's able to efficiently process info
-in ECM, every investment offers an expected return to match its level of risk
-if stocks were truly efficient, both technical and fundamental analysis would be useless
|
technical analysis |
-analysis of past stock prices and trading volume to forecast future prices
-traders, short term position
|
fundamental analysis |
-analysis of economy, industries, companies in attempt to find stocks that are overvalued or undervalued
-investors, long term
|
immediate adjustment |
-stock prices adjust to their new correct price within minutes
|
gradual adjustment |
stock prices adjust to their new correct price within hours of new info
|
random walk |
-future direction can't be predicted solely based on past movements
-imposible to predict short run changes in stock prices by looking at past price patterns and trading volume
-price changes are independent of one another
-in long run, most prices move with stocks long term growth of earnings and dividends
|
weak form efficiency |
-all past prices of stock and trading volumes are reflected in today's stock price
-just past info is included in prices
-daily stock price changes are independent
-technical analysis can't be used to predict or beat the market
|
semi strong form efficiency |
-all public info is reflected in stock's current price
-stok prices react quickly to new info, which prevents investors from earning abnormal returns
-neither technical or fundamental analysis can predict or beat market
-investors could still beat market with inside info
-most ppl believe this
|
strong form efficiency |
-all info public and non public is reflected in current price
-strongest form of market efficiency bc assumes that all info is included in stocks price
-investors can't beat the market, even with inside info bc that info is already included in the stock's current price
|
modern portfolio |
-assumes that all investors are rational, calculating, and intelligent investors who focus on stock prices
-behavioral finances shows that many investors don't always behave in rational manner
|
top findings of behavioral finance |
1. investors hate to lose, so have a tendency to hold onto losing stocks much longer than they should
2. investors often overreact or under react to new info
3. investors love to look for patterns and have a tendency to find them even when they don't really exist
4. investors tend to be overconfident in their ability to pick stocks and they tend to be overoptimistic about stock performance
|
Fama and french study |
-compared performance of the returns associated with portfolios of stocks that have certain similar characteristics
-research calls into question validity of ECM
|
Fama and french findings: |
1. portfolios of stock with high book value to market value ratio outperformed portfolios
2. low p/e ratios outperformed high p/e ratios
3. stocks with small market cap outperformed stocks with large market cap
|
mutual funds study 1 |
-studies show that half of mutual funds have positive alphas, based on gross returns
-half of mutual funds have negative alphas, based on gross returns
-shows that luck is most likely reason to explain mutual fund alphas
|
gross returns |
returns that investors earn before mutual fund fees are subtracted
|
net returns |
returns that investors earn after mutual fund fees are subtracted
|
mutual funds study 2 |
-funds with positive alphas over a 5 year period will likely have an avg alpha of zero over the next 5 year period
-past mutual fund performance doesn't predict future mutual fund performance
-no group of managers has been able to consistently show abnormally good investment returns
|
In efficient markets, we always expect an alpha of |
zero based on gross returns, regardless of past performance
-if investor has positive alpha for the last 5 years, that investor is still expected to have an alpha of zero for the next 5 years
-doing well doesn't make it more likely that you will do well again
ex. if you flip a coin 10 times and it lands on heads each time, there's still a 50-50 chance that it will be heads next time
-past performance doesn't predict future performance, so the expected alpha for mutual funds is always zero
|
in efficient markets, funds with the lowest fees will have the |
greatest alpha based on net returns
-net returns are always less than gross returns bc mutual fund fees are deducted to arrive at net returns
-avg alpha using net returns will be negative because of the fees charged by mutual funds
|
things that investors can minimize: |
1. trading costs
2. taxes
3. fees
|
bond indenture |
legal agreement between issuer of bond and trustee that represent stye investors who own bonds
|
trustee |
commercial bank monitors the terms of the bond indenture
-makes sure issuer abides by legal agreement
-collects interest and principal payments from the issuer and distributes those payments to bond holders
|
principal value, par amount, maturity value, face value |
amount that issuer pays bondholder when bond matures and principal payment is due
-usually $1000
|
interest rate or coupon rate |
amount of annual interest payment
|
current market interest rate vs bond's annual coupon (interest) payments |
bonds annual coupon payments can be anything the issuer wants
|
fixed rate/ fixed coupon bonds |
interest rate fixed for life of bond
-bond holder takes on interest rate risk associated with bond issue
|
fixed rate par value bond |
-when bond is sold for price equal to its maturity value
-bonds usually issued as par value bonds bc when bond is sold, its easy to set the bond's coupon rate equal to the current market interest rate
|
current market interest rate = bond's coupon rate |
when current market interest rate is exactly equal to the bond's coupon rate, the bond's price will be equal to the bond's maturity value
|
many investors don't hold bonds until maturity |
-sell on secondary market
-bond's price will be determined by the relationship between bond's coupon rate and the current market interest rate
|
fixed rate discount bond |
when current market interest rate is greater than bond's coupon rate, the bond's price will be less than the bond's maturity value
-current market interest rate > bond's coupon rate
-bond not giving as high rerun as the market says is fair
-investor pays the issuer of the bond an amount less than the maturity value of the bond
-issuer of bond still pays the investor the ill maturity value of the bond at the end of the bond's life
|
zero coupon bond |
bond with no coupon payments
-issuers only obligation is to pay bondholder full maturity value of the bond at the end of the bond's life
|
fixed rate premium bond |
-when current market interest rate less than bond's coupon rate
-bonds price will be greater than bond's maturity value
-investors willing to purchase bond at higher price than bond's maturity value
-compensated for premium paid on bond with larger coupon payments than par value bond would pay
|
floating interest rate structures |
bonds whose coupon rate adjusts to current market interest rate
-issuer of bond retains interest rate risk associated with bond issue
-less risky for investor
|
treasury bonds |
risk free
-largest and most fluid financial market
-bid ask spread is small
-pay interest every 6 months
|
treasury yield curve |
acts as a set of base yields from which all other debt securities are prices
|
municipal bonds |
-issued by cities, states, municipalities
-exceppt from federal and state and local taxation**
-willing to accept lower yields compared to corporate and treasury bonds bc tax exempt
|
taxable equivalent yield= |
r / (1 - tax rate)
-allows investors to relate the return on municipal bond to current market interest rate and other bonds
|
Ways municipal bonds are secured |
1. general obligation bonds: bonds that are secured by the issuer's taxing power
2. revenue bonds: bonds secured by revenues from facility or system constructed with the proceeds of the bonds
3. credit enhancement devices: secured with municipal bond insurance or bank letters of credit
|
corporate bonds |
-capital intensive and stable industries
-only source of security is unsecured promise by corporation to pay off debt
|
restrictive covenants |
-covenants in bond indenture that require company to perform certain actions or prevent company from performing certain actions
ex. required to keep assets in good working order or to maintain a minimum working capital ratio
ex. company prohibited from merging with another company or issuing additional debt
|
spread to treasuries |
measure of default risk
=yield on corporate bond - yield on treasury with same maturity
|
convertible bonds |
pay a fixed rate of interest
-can be converted into fixed number of shares of stock in corporation
-investors willing to accept lower rate of interest bc of conversion
|
asset backed debt |
bonds secured by portfolio managers on single family homes or loans
-created by sponsor (financial institution)
-sponsor structures financing and usually purchases credit enhancement in form of insurance
|
callable bonds |
allows issuer to buy back bonds prior to state maturity
-will exercise call option if interests rates drop and issuer can refinance
-if interest rates drop low enough, issuer can issue new bonds to pay off existing bonds allowing issuer to refinance its debt at lower interest rate
-investors require higher rate of return
-investor also receives call premium
|
call premium |
amount call price is above bond's par value
-can be exercised on or after predetermined date that's usually 5 or 10 years
|
investment grade bond |
level BBB- or better
|
reinvestment risk |
risk related to the fact that investors don't know future interest rates
|
zero coupon bonds |
don't have reinvestment risk bc no coupon payments
|
prepayment risk |
risk that bond will be called by issuer and retired before its maturity date
-only applies to callable bonds
|
interest rate risk |
risk that changes in market interest rates will negatively impact value of bond
-price sensitivity
|
longer the maturity of a bond, the greater the bond's |
price volatility:
-what all other factors are held equal, long term bonds are more affected by changes in market interest rates than short term bonds
|
the lower the coupon on the bond, the higher the bond's |
price volatility
-bonds with low coupon rates are more sensitive to changes in the market interest rate than bonds with high coupon rates
|
duration |
how long it takes to get your money back
-measured in units of time
-zero coupon bonds are simplest bonds in terms of duration bc it's equal to the bond's current time to maturity
-larger coupons=shorter duration
|
longer duration= |
more interest rate risk
|
yield curve |
-used to describe relationship between yield on bond and maturity
-aka term structure of interest rates
-securities differ only in maturity
|
upward sloping yield curve |
normal shape
-bonds with longer maturities have higher yields than bonds with shorter maturities
|
downward sloping yield curve |
-when significant slowdown inflation is anticipated
-bonds with shorter maturities have higher yields than bonds with longer maturities
|
3 factors that affect shape of yield curve |
1. rate of inflation/deflation
2. economy
3. monetary policies
|
3 common explanations for shape of yield curve |
1. pure expectations hypothesis
2. liquidity preference hypothesis
3. market segmentation hypothesis
|
pure expectations hypothesis |
yield is analyzed as a series of expected future short term interest rates where a series of expected short term spot rates will reproduce the observed market rates expressed in the yield curve
-expected average annual return on a long term bond is the compound avg of the expected short term interest rates
ex. investor is expected to earn same return from buying 10 year bond, 10 consecutive 1 year bonds, or 2 consecutive 5 year bonds
-implies that investors don't earn a greater yield from purchasing long tier bonds than they do from purchasing many consecutive short term bonds
-flat yield curve
|
liquidity preference hypothesis |
investors prefer to hold short term maturity securities so investors are going to require higher interest rates, known as liquidity premium, for them to hold bonds with longer maturities
-long term interest rates are composed of expected short term interest rates plus a liquidity premium
-liquidity premium increases with time to maturity
-upward sloping yield curve
|
market segmentation hypothesis (preferred habits hypothesis) |
market is made up of diverse group of investors where some investors prefer short term investments and some prefer long term
-most investors prefer to invest so that the life of their assets matches the life of their liabilities
-if issuer of bond wants an investor to move away from investor's preferred position on yield curve, issuer must pay a premium
-shape of yield curve depends on supply and demand
|
nominal interest rates |
actual observed rate of return on investment
-don't take into account inflation or deflation
-have to compare nominal interest rates to rate of inflation to determine effect on purchasing power of your money
|
real interest rate= |
nominal rate of interest - inflation rate
-difference between the nominal rate of interest and rate of inflation
|
investors value bonds based on "price to worst" call feature scenario |
investors assume issuer of bond will always act in its own best interest in calling or managing a bond's call features, which means that issuer will exercise bond's call option at the first opportunity it's economically advantageous to do so
|
i input is |
bond's yield
|
pmt input is |
bond's coupon rate
|
calculate with |
semiannual numbers!!!!
|
pv is |
current price of bond
|
fv is |
maturity value (face value) of bond
|
if interest rates drop, issuer will |
call bonds as soon as possible
-life of bond is only length of time left until issuer is allowed to call bond
|
call premium |
expressed as a percent
-only take into account when bond is being called
|
market interest rate < coupon rate |
interest rates have decreased so bond will be called
|
Direct relationship between |
company's profit and the market value of its stock
-inc profits: inc value of company
|
indirect relationship between |
interest rates and stock values
-inc. int. rate dec stock values
|
perpetuity |
set payment amount that continues infinitely on regular intervals
-corporations have infinite life so stock valuation procedure should be able to value cash flow to infinity
|
factors that cause stock price to decrease that are outside company's control |
1. inc interest rate
2. lower earnings forecasts for industry and market
3. fears of inflation or deflation
4. corporate governance/acctg scandals
5. terrorist attacks
6. international economic or currency crisis
|
factors that cause stock price to inc. |
1. positive economic events
2. breakthrough in technology
3. if company is a target of a takeover bid and there's a tender offer for company's stock
|
capital gains |
stock price inc. over time
|
info content of dividends |
-stock prices inc when dividends inc bc of information about dividend chang
-managers inc dividends when they expect higher earnings in the future
|
3 most important dividend policy issues |
1. firm determines its dividend policy based on its investment and growth opportunities
2. firm's stock price tends to inc when firm inc its dividend and vise versa
3. change in firms stock price is not to the dividend itself, it's due to the info conveyed by announcement
|
dividend policy should not affect |
current value of a stock
-Modigliani and Miller showed that current value of stock price doesn't depend on firm's dividend policy
|
However, expected future value of stock is |
greatly affected by dividend policy
|
technical analysis |
stock analysis based on belief that prices are influenced more by psychology and emotions
-historic stock price movements, volume of trading
-trade stocks frequently
-traders
-buy low sell high
-timing is important
|
fundamental analysis |
based on determining stock's intrinsic value and assumption that company's stock price will move to its intrinsic value over time
-look at overall economic industry, company data to value stock
-warren buffet
|
intrinsic value |
true value of company's stock
-function of company's revenue, growth, earnings, dividends, cash flows, profit margins, risk etc
-in short run company's stock price may move away from intrinsic value
-long run, company's stock price will return to intrinsic value
-investors want stocks that are priced below intrinsic value
|
3 methods used in fundamental analysis |
1. target stock price
2. relative valuation
3. DCF
|
1. target stock price analysis |
-forecast firm's EPS and then multiply EPS by P/E to get target price
-if target stock price is below actual stock price, its a good buy
|
2. relative valuation |
-compare company's measures of value
-usually used with target stock price analysis
|
3. DCF |
-sum of company's future cash flows discounted back to today's dollars
|
Dividend discount model |
-most basic DCF approach
-value of stock is present value of dividends investor expects to receive from stock if investor holds stock forever
|
Free cash flow to equity (FCFE) model |
-measures company's cash flows after accounting for payments for working capital, capital expenditures, interest, and principal on debt, dividends on preferred stock, then discounts those cash flows at company's cost of equity to arrive at value
|
Free cash flow to the firm (FCFF) model |
-main type of DCF
1. forecast company's expected cash flows
2. estimate company's WACC
3. calculate enterprise value of company
4. calculate intrinsic stock value
|
WACC is |
the discount rate used to value the company's stock
|
Modern portfolio theory |
-stock prices always reflect intrinsic value and any type of fundamental ro technical analysis si already embedded in stock price
-cornerstone concept of ECM
-useless to search for undervalued stocks
|
excess return period |
period where return company earns on new investment is greater than company's WACC due to competitive advantages over other firms in industry
-more competition=shorter excess return period
-once company loses competitive advantage, returns from its investment will be equal to company's wacc
-when return on investment is equal to wacc, means that NPV of investment is 0
|
companies relative to excess return period |
1. boring companies: 1 year excess return period
2. decent companies: 5 year
3. good companies: 7 year
4. great companies: 10 year
|
residual value |
once company loses its competitive advantage, company's after tax earnings can be treated and valued as a perpetuity
-residual value found by discounting value of perpetual cash flows back to today's dollars using WACC
|
financial slack is |
firms excess ash and used debt capacity
|
use ____ value of debt and equity in wacc |
market value
|
ways to reduce risk |
1. diversification
2. hedging
3. insurance
|
efficient frontier |
-achieving highest possible return for given level of risk
-rational investors try to maintain efficient frontier
|
statman study |
more stocks=lower std. dev.=lower risk
-volatility of 10 stock to 1000 stock portfolio is not that different
-20 to 25 stocks is sufficient
|
correlation |
how change in stock A's price will affect stock B's price
-correlation of 1: if stock A increases by 10%, B will also increase by 10%
-correlation of 0: perfectly uncorrelated, no effect on each other
-correlation of -1: 10% A will lead to -10% B
|
High correlation: |
less risk reduction
-if you buy a bunch of stocks that are closely correlated, you won't be diversifying as much
-when diversifying, you want stocks that aren't correlated
|
hedging |
reducing exposure to decrease or inc in price of asset or return associated with investment
-sacrificing gains to protect against loss
|
3 types of hedging |
1. forward contracts
2. future contracts
3. swaps
|
forward contract |
-agreement where one party agrees to buy commodity at a specific price on specific future date
-goods are delivered under forward contracts
-not traded on organized exchange
|
future contracts |
-forward contract with standardized terms that trades on org. exchange
-physical delivery of asset never taken
-2 parties settle up with cash for difference between contracted price and actual price on expiration date
|
swaps |
two parties agree to swap something, generally obligations to make specified payment streams
-involve payments or currencies
|
hedgers vs speculators |
hedgers: use financial instruments to reduce risk
speculators: use financial instruments to increase risk
|
long positions vs short positions |
-long position: party that agrees to buy the contract
-make money when value of asset inc.
-short position: party agrees to sell contract: make money when value of asset decreases
|
spot price |
current market price for immediate delivery of commodity
|
forward price |
price paid today for delivery of commodity in future
|
insurance cap |
limit on amount of money that can be paid under insurance claim
|
options |
right to sell an asset or purchase an asset at fixed price at a fixed time in future
|
strike or exercise price |
price at which option may be exercised
|
expiration date |
last date that option can be exercised
|
"in the money" |
when option creates value for the option holder
|
call option |
-option to buy at the strike price
-call option is in the money when current market price is greater than strike price
|
put option |
option to sell at the strike price
-in the money when current market price is less than strike price
|
intrinsic value |
-amount the option is in the money
-difference between current price and strike price
|
time value |
reflects expectations of option's profitability associated with exercising it at some future point
|
derivative securities |
-financial instrument that derives its value from another security
-more sensistive to price or yield change
-attractive to hedgers
|
equity and debt components |
derivative security embedded with characteristics of simple stock or bond
|