Finance 3000 Exam 2 - Mizzou/Griswold

financial markets

arenas through which funds flow

what are the two major market dimensions?

-primary vs secondary

-money vs capital

primary market

markets in which corporations raise funds through new issues of securities

secondary market

markets that trade financial instruments once they are issued

example of secondary markets

NYSE and NASDAQ

money markets

trade debt securities or instruments with maturities of less than one year

capital markets

trade debt and equity instruments with maturities greater than one year

examples of money market instruments

-treasury bulls

-federal funds

-repurchase agreements

-commercial paper

-negotiable certificates

-banker acceptances (BAs)

what does FDIC insurance do?

prevents runs on banks

foreign exchange markets

trade currencies for immediate (spot) or some future stated delivery

foreign exchange risk

arises form the unknown value at which foreign currency cash flows can be converted into U.S. dollars

derivative security

formalizes an agreement between 2 parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future

what are three characteristics of derivative securities

-highly leveraged financial securities linked to underlying security

-potentially high-risk

-used for hedging and speculating

financial institutions

perform the essential function of channeling funds from those with surplus funds to those with shortages of funds

what unique functions are performed by financial institutions?

-monitoring costs

-liquidity and price risk

nominal interest rates

observed in financial markets and most often quoted by financial new services

loanable funds theory

view equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds

what factors influence interest rates?

-inflation

-real risk-free rate

-default risk

-liquidity risk

-special provisions regarding use of funds raised by a particular security issuer

-security's term to maturity

inflation

continual increase in price level of a standardized basket of goods and services

real risk-free rate

rate that risk-free security would pay if no inflation were expected over its holding period

what is does the fisher effect explain?

the relationship between real risk-free rate, expected inflation, and nominal risk free rate

what is the nominal risk free rate formula?

expected inflation + real risk-free rate

what is the formula risk-free rate?

nominal risk-free rate - expected inflation

default/credit risk

risk that a security issuer will default on that security by being late on or missing an interest or principal payment

liquidity risk

risk that a security can't be sold at fair-market price with low transaction costs on short notice

term structure of interest rates (yield curve)

comparison of market yields on securities, assuming all characteristics (except maturities) are equal

examples of capital market instruments

-treasury notes & bonds

-U.S. govt agency bonds

-state & local govts

-mortgages

-mortgage-backed securities

-corporate bonds / stocks

which market is bigger, the stock or bond market?

bond market is 2x bigger than the stock market

which is more risky, stocks or bonds?

stocks are more risky

bond

publicly traded form of debt

indenture agreement

legal contract describing the bond characteristics and the bondholder and issuer rights

treasury inflation - protected securities (TIPS)

U.S. government bonds where the par value changes with inflation

U.S. government agency securities

debt securities issued to provide low-cost financing for desirable private-sector activities such as home ownership, education, and farming

mortgage-backed securities

represent a claim against the cash flows from a pool of mortgage loans

premium bond

sells for price greater than its par value

discount bond

sells for a price lower than its par value

zero coupon bond

doesn't make interest payments but generally sells at a deep discount and then pays the par value at the maturity date

what is the formula for current yield?

annual coupon / bond price

yield to maturity (YTM)

reflects the total return the bond offers if purchased at the current price and held to maturity

taxable equivalent yield

modification of muni bond's yield to maturity used to compare muni bonds yields to taxable bond yields

what is the formula for equivalent taxable yield?

muni yield / (1-tax rate)

credit quality risk

chance the issuer will not make timely interest payments or even default

bond ratings

grade of credit quality as reported by credit rating agencies, are used to assess credit quality risk

investment grade

bonds are high credit quality corporate bonds

junk bonds

low credit quality corporate bonds (aka speculative bonds or high-yield bonds)

what are characteristics of the bond market?

-decentralized, over-the-counter trading

-between bond dealers & large institutions

-NYSE operates largest centralized U.S. bond market

common stock

ownership stake in a corporation

stock index

used to measure the performance of particular group of stocks

Dow Jones Industrial Average (DIJA)

tracks 30 large, industry-leading firms

Standard & Poor's 500 Index (S&P 500)

tracks 500 large companies

NASDAQ Composite Index

technology-firm weighted index of stocks listed on NASDAQ

quoted bid

highest price the market maker offers to pay for the stock

quoted ask

lowest price the market maker will sell a stock

what is the spread?

between the bid price and ask price is a cost to the investor and profit for the market maker

market order

a stock buy or sell order to be immediately executed at the current market price

limit order

-stock buy or sell order at a specific price

-only executed if market price = specified price

preferred stock

hybrid security that has characteristics of both long-term debt and common stock

market capitalization

size of the firm measured as the current stock price multiplied by the number of shares outstanding

risk

volatility of an asset's returns over time

diversification

-process of putting money into different types of investments for the purpose of reducing the overall risk of the portfolio

-can eliminate firm specific risk

-comes from micro-events of the firm/industry

what are the conditions to use the constant growth model?

-"g" to be constant

-"i" has to be greater than "g"

dollar return

amount of profit or loss from an investment denoted in dollars

percentage return

dollar return characterized as a percentage of money invested

what is the formula for dollar return?

(ending value - beginning value) + income

what is the formula for percentage return?

(ending value - beginning value) + income / beginning value

* 100%

average returns

summarize the past performance of an investment and allow us to examine performance over time

standard deviation

measure of past return volatility, or risk, of an investment

what is an assumption of standard deviation and risk?

higher the standard deviation, the higher the risk

coefficient of determination

relative measure of risk vs reward relationship

portfolio

combination of investment assets held by an investor

Capital Asset Pricing Model (CAPM)

best-known asset pricing equation

asset pricing

attempt to specify an equation that relates a stock's required return to an appropriate risk premium

security market line

shows how required return relates to risk at any particular time, all else held equal

beta

measures the sensitivity of a stock or portfolio to market risk

what are the assumptions about beta?

-Beta > 1 means more risky than market (higher risk premium)

-Beta < 1 means less risky than market (lower risk premium)

what is the formula for expected return?

risk free + beta (market risk premium)

efficient market

one in which prices fully reflect available information on each security

effective market hypothesis

states that security prices fully reflect all available information

behavioral finance

study of the cognitive processes and biases associated with making financial and economic decisions

market segmentation theory

individual investors and financial institutions have specific maturity preferences, and to encourage buyers to hold securities with maturities other than their most preferred requires a higher interest rate

unbiased expectations theory

the theory of term structure of interest rates that says that, at any given point in time, the yield curve reflects the market's current expectations of future short-term rates