Finance 301 Exam 3

Federal Discount Rate Rate that the federal reserve offers to commercial banks for overnight reserve loans
Federal Funds Rate Rate commercial banks charge each other for overnight loans
LIBOR Rate offered by London commercial banks for $-denominated deposits of other banks. Bank lending rates are often quoted as LIBOR+Premium
Prime Rate Rate that large commercial banks charge their most creditworthy customers
Two Primary Types of Financial Capital -Debt(bonds)-Equity
Interest Rate “Cost of Money”-The price lenders receive and that borrowers pay for debt capital.-For bonds the capital allocated through a price system based on supply and demand
Supply of Money Higher the interest rate, the more people will be willing to lend their money to others
Demand for Money Lower the interest rate, the more people want to borrow money
Factors Affecting Interest Rates -Rates that the corp expect to earn with the money they’re borrowing-The saver’s time preference for current vs. future consumption-The riskiness of the loan-Inflation expectations
The higher the risk of the loan… the higher the required rate of return
The higher the inflation… the higher interest rates have to be to keep pace
The Real Rate of Interest Nominal Rate(r-nom)= Real rate of interest(r*)+inflation
Real Risk-Free Rate(r*) The rate on short term US Treasury securities assuming there is no inflation
Maturity Risk Premium(MRP) -The premium that reflects the risk associated with changes in interest rates for a long term security-The longer the maturity of a bond, the more exposure it has to interest rate risk, so long-term bonds have a higher interest rate than short-term bonds to compensate investors for the risk
Inflation Premium(IP) Premium that reflects the risk associated with changes in inflation for a long-term security
Liquidity Risk Premium(LP) Premium added when a security lacks marketability, because it cannot be bought and sold quickly without losing value
Nominal Risk-Free Rate(rRF) The rate for a riskless security that is exposed to changes in inflation
Cross-Rate Effect for Nominal and Real Int Rates Nominal Rate(r-nom)=real rate of interest(r)+ interest(i)+(r x i)
Risk Free Rate(rRF) The rate paid on riskless security(US T-Bill 3-months)
Inflation Expectations Average inflation expected over the life of the security
The higher the expectations for inflation… the higher interest rate will be today
The great the risk of default… the higher the interest rate required to satisfy potential investors
Default Risk Premium(DRP) -Difference between the interest rate on a US Treasury bond and a corporate bond of the same profile(same maturity/marketability)-The risk that a borrower will default, affects the interest rate:
Corporate Bond Spreads(default premium) -Spread is the amount of additional yield above and beyond a benchmark-10 year US treasury is often used as a benchmark
High Yield vs Investment Grade Corporate Bonds The spread between investment bonds and high yield(junk) bonds
Liquidity Premium(LP) Premium added to the equilibrium interest rate on a security if that security cannot be converted to cash quickly and at its fair market value
Term Structure -Relationship between interest rates and maturities
Yield Curve -Graph used to show term structure-Usually upward-sloping
Monetary Policy Federal Reserve Bank will change interest rates to bring about desired outcome
Effect of Economic Boom on Interest Rates Raise rates to slow-down an economy and hold down inflation
Effect of Recession on Interest Rates Lower rates to make money cheaper which spurs the economy
Federal Deficits -US government runs huge deficits so they have to borrow money. -This increased demand for borrowing drives up interest rates
The larger the federal deficit… interest rates and risk of default rise
Pure Expectations Theory The shape of the yield curve depends on investors’ expectations about future interest rates
Bond long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bonds
Types of Bonds -Treasury Notes/bonds-Corporate Bonds-Municipal Bonds-Foreign Bonds
Treasury Notes/Bonds Issued by US Government of various maturities(2-30 years)
Par Value Also known as ‘face value’ or principal; it is the amount originally loaned
Coupon Rate Interest rate, stated annually, that the bond will pay
Coupon Dollar amount of interest paid
Maturity Date Set date when the par value is paid back to the bondholder
Call Provisions Callable bond is one which the issuer can pay you back prematurely
Sinking Fund Provision When issuer is required to retire a portion of bond issue each year
Convertible Bonds Bonds that can convert into the common stock of the company
Bond Valuation Value of anu financial asset is the present value(PV) of the cash flows the asset is expected to generate over time
A bond is worth its par on day 1, but… after that its value will fluctuate as market interest rates move up and down
When Interest Rates Rise, the Value of a Bond… Declines
When Interest Rates Fall, the Value of a Bond… Rises
(Price)When Investors Demand More Bonds… it will drive up the price of the bonds
(Int Rate)When Investors Demand More Bonds… they supply more money to market, driving interests rates down
Premium Bonds -Bond Price>Par Value-Coupon Rate>Current Yield>YTM
Par Bonds -Bond Price=Par Value-Coupon Rate=Current Yield=YTM
Discount Bonds -Bond Price<Par Value-Coupon Rate<Current Yield<YTM
The Price of a Bond Determines… What return you will get
The Higher You Pay for a Bond… The lower your yield/return will be
Yield To Maturity(YTM) -Annual rate of return earned on a bond if held to maturity -Considered a long-term bond but expressed as an annual rate
Yield To Maturity= Current Yield+Capital Gains YIeld
Current Yield(CY) -Annual interest earned relative to the current price of the bond- Current Yield=(Annual Coupon Payment)/(Price of Bond)
Capital Gains Yield(CGY) Calculated as the bond’s annual change in price divided by the beginning of year price
Interest Coupon Payments+Capital Appreciation= Annual return(yield) on the bond held
Callable Bonds -Bonds that can be redeemed prior to maturity date by the borrower-Almost all bonds issued today are callable-Requires borrower to pay an amount above par value(premium)
Call Premium -Additional amount paid above par value for bonds that have been called-Can be a % of par, or one year’s interest
Deferred Call Provision Bond can’t be called until certain amount of time has passed since original issuance date
Yield-to-Call(YTC) Rate of return earned on a bond if held until it is called
Semi-Annual Compounding -Divide annual coupon payment by 2-Multiply years to maturity by 2-Divide APR(nominal/quoted rate) by 2 to determine periodic rate
Zero Coupon Bonds -Bonds which never pay interest. They are sold at a steep discount to par, the difference representing the cumulative interest earned over the life of the Bond-Ex: US Savings Bonds
Two Primary Risks Associated with Bonds -Interest Rate Risk-Reinvestment Risk
Interest Rate Risk -Risk that as interest rates increase, the value of the bond declines-Longer the maturity, the more interest rate risk increases
Reinvestment Risk -Declining rates hurt short-term bondholders who need to reinvest-Affects income level coming from bond investment
The Lower the Rates… the More Likely a Bond Gets Called
Clean Price Price of the bond by itself
Dirty/Invoice Price Bond Price+Accrued Interest
Investment Grade Bonds rated triple-B(S&P) or higher
High Yield aka Junk Bonds rated below triple-B
S&P Bond Ratings Investment Grade:1. AAA2. AA3. A4. BBBJunk:5. BB6. B7. CCC8. C
3 Primary Types of Financial Securities Companies Issue to Raise Capital 1. Bonds2. Preferred Stock3. Common Stock
Characteristics of Common Stock -Ownership-Residual Claim-Dividends-# of Shares Outstanding
Ownership -Own and control company-Elect Board of Directors, who in turn, choose management
Residual Claim -Right to the rewards of running the business-What belongs to common stockholders after all creditors, debt holders, and gov have been paid
Dividends -May or may not receive returns in the form of a dividend-Usually Paid Quarterly-Taxable to investor, not deductible on tax returns for company
# of Shares Outstanding -Amount of shares sold to public
Treasury Stock Shares which the company has repurchased from public
Private Equity When companies seek financing from private parties, as opposed to issuing stock to the public
Public Financing When companies issue securities to the public
Primary Market -Where companies go to sell its stock(IPO)-Primarily done through investment banks
Secondary Market -Where investors can buy/sell their stock from other investors -NYSE and NASDAQ
Bull Market A prolonged, rising stock market
Bear Market A prolonged, declining stock market
Ways to Value Shares of a Company -Dividend Discount Model(DDM)-Discounted Cash Flow Method(Corp Valuation Model)-Using price multiples of similar firms(Relative to Comparables)
Dividend Discount Model(DDM) -Value of a stock is the present value of the future dividends expected to be generated by the stock-If constant, we value it like a perpetuity
Holding Period Return(HPR) Percentage change of the gain/loss relative to the original cost of teh investment
Coefficient of Variation(CV) -Standardized measure of the amount of risk per unit of return-CV=(Standard Deviation)/(Expected Return)
Expected Return(ER) of an Asset The sum of the probabilities multiplied by their respective expected returns
Expected Return of a Portfolio of Assets The weighted average of the expected return of each of the investments within the portfolio
Risk Probability that some unfavorable event will occur or the probability is uncertain
Risk Aversion -Rational investors prefer less risk
The Higher the Risk… the higher return required to attract investors
When a Stock has a Favorable Expected Return -Buyers will purchase stock, driving up price-Price moving up will decrease the future expected return of the stock
Premise An efficiently diversified portfolio will yield the greatest return for a given level of market risk
Systematic/Market Risk Unpreventable risk that is associated with having stock in the market
Total Risk= Company-Specific Risk + Market Risk
Beta Coefficient(B) -Metric that shows the extent to which a given stock’s returns move up and down with the stock market-Measures market risk
Systematic Risk Principle Reward for bearing risk depends solely on the amount of systematic risk of an investment. The unsystematic risk, while present, can easily be diversified away; thus, the market is not going to reward risk borne unnecessarily
The Beta of a Risk-Free Asset(US T-Bill)= 0
Market Risk Premium -Additional amount of return over the risk-free rate needed to compensate investors for assuming an average amount of market risk-Equity Risk Premium=(Market Return)-(Risk-Free Rate)
Capital Asset Pricing Model(CAPM) Determines required rate of return for a stock
Required Return= (Risk-Free Rate)+(Risk Premium for the Stock’s Perceived Risk) or(Risk-Free Rate)+(Market Risk Premium-Risk Free Rate)*(Beta Coefficient)
Current Yield= Annual Interest/Current Price
Total Yield= Dividend Yield+Capital Gains Yield
Price= Div(o)*((1+g)/(g-r))

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