Finance Exam 2 (ch.5,6,7,8)

\-production opportunities

\-time preferences for consumption

\-risk

\-inflation

what are the fundamental factors that affect the cost of money?

production opportunity

the return available within an economy from investment in a productive asset

time preference for consumption

the preference of a consumer for current consumption as opposed to saving for future consumption

high time preference for consumption

needing a large portion of your income supporting your family, which leaves little to save for future needs

low time preference for consumption

uses small portion of income to support basic needs, which allows for saving of income for future use

risk

the chance that a financial asset will not earn the return promised

inflation

the tendency of general prices to increase over time

nominal (or risk free rate)

the interest rate on a security that has absolutely no risk at all - one that has a guaranteed outcome in the future, regardless of the market conditions

real risk-free rate of interest

the interest rate that would exist on a risk-free security if inflation is expected to be zero during the investment period

inflation premium

a premium investors add to the real risk-free rate of return to account for inflation that is expected to exist during the life of an investment

default risk premium

the difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability; compensation for the risk that a corporation will not meet its debt obligations

liquidity premium

a premium added to the rate on a security if the security cannot be converted to cash on short notice at a price that is close to the original cost

true

the price of long-term bonds decline (increase) whenever interest rates rise (decline). true or false

maturity risk premium

a premium that reflects interest rate risk; bonds with longer maturities have greater interest rate risk because their prices change more than prices of shorter-term bonds for a given change in market rates

yield curve

a graph showing the relationship between yields and maturities of securities on a particular date

\-changes both in position and in slope over time

normal yield curve

\-upward sloping

\-when long-term rates are higher than short-term rates

inverted yield curve

\-downward-sloping

\-short-term rates are higher than long-term rates

expectus theory

the slope of yield curve is in the same direction as expected interest movements

liquidity preference theory

investors prefer more liquidity to less, which means they are willing to pay higher prices for more liquid investments

market segmentation theory

market is segmented by maturity

supply of money

primarily controlled by the federal reserve

demand of money

determined by market participants

open market operations

fed buys and sells government securities to change the supply of money in the economy

sell government securities

(when the fed sells securities, investors purchase with money, which reduces the supply of money in the economy)

if the fed wants to increase interest rates, should it buy or sell government securities?

buy government securities

if the fed wants to decrease interest rates, should it buy or sell government securities?

discounted securities

securities that sell for less than their par values when issued

true

interest is paid to bondholders before dividends are paid to stockholders. true or false

true

Corporate debt holders do not have voting rights, so they cannot attain control of the firm. true or false

treasury bills

discounted securities issued by the U.S. government to finance its operations and programs

\-prices are determined by an auction process

\-maturity date ranges from a few days to 52 weeks

repurchase agreement

\-short term debt instrument

\-an arrangement whereby a firm that needs funds sells some of its financial assets to another firm that has excess funds to invest, with a promise to repurchase the securities at a higher price at a later date

\-usually only last a few hours

federal funds

\-short-term debt instrument

\-represent loans from one bank to another bank

\-banks use this market to adjust their reserves

\-banks who need more money borrow from banks with excess reserves, and vice versa

\-very short maturities, often overnight

banker’s acceptance

\-short-term debt instrument

\-An instrument issued by a bank that obligates the bank to pay a specified amount at some future date

\-generally used in international trade

commercial paper

\-short-term debt instrument

\-does not pay interest, so issued at a discount

\-A discounted instrument that is a type of promissory note, or “legal” IOU, issued by large, financially sound firms

\-usually sold to other businesses

eurodollar deposits

\-short-term debt instrument

\-a deposit in a bank outside the United States that is not converted into the currency of the foreign country; it is denominated in U.S. dollars

\-not exposed to exchange risk

money market mutual funds

\-short-term debt instruments

\-consist of investment dollars that are pooled to purchase large amounts of short-term financial assets

\-professionally managed by firms, that specialize in investing money provided by many individual investors

certificates of deposit

\-short-term debt instruments

\-An interest-earning time deposit at a bank or other financial intermediary

term loan

\-long-term debt instrument

\-a contract under which a borrower agrees to make a series of interest and principal payments to the lender on specific dates

\-negotiated directly between the borrowing firm and a financial institution

bond

\-long-term debt instrument

\-a borrower agrees to make payments of interest and principal on specific dates to the bondholder

government bonds

\-long-term debt instrument

\-issued by the U.S. government, state government, and local governments

\-issued by the U.S. Treasury

municipal bonds

\-long-term debt instruments

\-issued by state and local governments

corporate bonds

\-long-term debt instruments

\-issued by businesses

\-is generally advertised, offered to the public, and sold to many different investors

\-interest rate is typically fixed

mortgage bond

\-long-term debt instrument

\-A bond backed by tangible (real) assets. First-mortgage bonds are senior in priority to second-mortgage bonds

debenture

\-long-term debt instrument

\-unsecured bond, provides no claim, against specific property as security for the obligation

\-these holders are generally creditors whose claims are protected by property not otherwise pledged as collateral

income bonds

\-long-term debt instrument

\-pay interest only when the firm generates sufficient income to cover the interest payments

\-missing these interest payments on these securities cannot bankrupt a company

\-these bonds are riskier than bonds that require fixed interest payments for investors

putable (retractable) bonds

\-long-term debt instruments

\-bonds that can be turned in to the firm prior to maturity in exchange for cash at the bondholder’s option on specific dates or if the firm takes some unusual actions

indexed

\-long-term debt instrument

\-pay interest based on an inflation index, such as the consumer price index

\-the interest paid rises automatically when the inflation rate rises, thereby helping to protect bondholders against purchasing power losses

floating-rate bonds

\-long-term debt instrument

\-A bond whose interest payment fluctuates with shifts in the general level of interest rates

\-In many cases, limits are imposed on how high and low the rates on such debt can go

zero coupon bonds

\-long-term debt instrument

\-A bond that pays no annual interest but sells at a discount below par, thus providing compensation to investors in the form of capital appreciation

junk bond

\-long-term debt instrument

\-A high-risk, high-yield bond; used to finance mergers, leveraged buyouts, and troubled companies

preferred stock

\-considered a hybrid security because it is similar to bonds in some respects, and common stock in other respects

\-stock issued by a corporation that has preference with regard to payment of dividends

cumulative dividends

A protective feature on preferred stock that requires preferred dividends not paid in previous years to be disbursed before any common stock dividends can be paid

characteristics of preferred stock

\-constant dividend

\-call provision

\-convertible feature (can be turned into common stock)

\-earnings paid after debt, but before common stock

\-no voting power

common stock characteristics

\-owners of the firm

\-earnings/proceeds paid after debt and preferred stockholders

\-can have dividends, but not normally fixed

\-dilutes ownership

\-can vote for members of the board

preemptive right

\-requires a firm to offer existing common stockholders shares of a new stock issue in proportion to their current ownership holdings before such shares can be offered to other investors.

classified stock

Common stock that is given a special designation, such as Class A, Class B, and so forth, to meet special needs of the company

founders’ shares

Stock, owned by the firm’s founders, that has sole voting rights but generally pays out only restricted dividends (if any) for a specified number of years

american depository receipts

“Certificates” traded in U.S. stock markets that represent ownership in stocks of foreign companies and are held in trust by banks located in the countries where the stocks are traded

\-provide U.S. investors the ability to invest in foreign companies with less complexity and difficulty than might otherwise be possible

euro stock

Stock traded in countries other than the home country of the company, not including the United States

yankee stock

Stock issued by foreign companies and traded in the United States

stand-alone risk

risk of an investment if it was held by itself

portfolio risk

risk of an investment when it is combined in a portfolio with other investments

standard deviation

measures the tightness, or variability, of a set of outcomes, or a probability distribution

true

the tighter the distribution, the less the variability of the outcomes and the less risk associated with the event

risk averse

investors require higher rates of return to invest in higher-risk securities