Investment Analysis Ch 1-2

What is an investment?

Giving up current consumption to invest for future consumption.

Real assets

Physical assets that produce goods/services (machines, land, buildings).

Financial assets

A claim on income generated by real assets (stocks, bonds).

What are the three types of financial assets?

Fixed income securities, common stock, derivatives.

Fixed income securities

Debt instruments, primarily bonds, that allow investors to lend money to corporations or governments in exchange for regular interest payments and the return of principal at a defined maturity date.

Common stock

represents an ownership stake in a given company

Derivative security

financial contracts that derive their value from an underlying asset, such as stocks, bonds, commodities, currencies, or market indexes

Asset allocation

Deciding how much to invest in each asset class

Security selection

Choosing specific securities within an asset class

Risk return tradeoff

Higher expected return requires higher risk

Efficient market

Prices reflect all available information

What are the main players in financial markets?

Firms, households, governments, financial intermediaries.

Market capitalization

Total value of a company’s shares

Globalization

The integration of financial markets across countries, allowing investors to buy and sell securities worldwide

Securitization

The process of pooling financial assets (like loans or mortgages) and turning them into tradable securities

Financial engineering

Options strategies, structured products, or new derivative securities

Why is financial engineering used?

To manage risk, improve returns, or design customized investments

What role do computer networks play in investing?

They allow faster trading, global market access, and real-time information flow

Why are computer networks important to financial markets?

They increase market efficiency, liquidity, and speed of transactions

Mega cap

$200 billion and over

Large cap

$10 billion and over

Mid cap

Between $2 billion and $10 billion

Small cap

Between $300 million and $2 billion

Micro cap

Under $300 million

Formula for current yield

Annual dollar coupon interest / Price

What does current yield measure?

Income return relative to bond price.

Formula for holding period return (HPR)

(Ending price + distributions - beginning price) / beginning price

What does holding period return measure?

Total return over the investment period.

Formula for dividend yield

Dividend per share / market price per share

What does dividend yield measure?

Cash return from dividends relative to stock price.

Constant growth dividend model

P₀ = D₀ (1+g) / d(r − g)

What does D₁ represent in the constant growth model?

Dividend next period.

What does r represent?

Required rate of return.

What does g represent?

Dividend growth rate.

What happens if g increases?

Stock price increases.

What happens if r increases?

Stock price decreases.

What is a money market instrument?

Short-term debt security.

Examples of money market instruments

T-bills, CDs, commercial paper, repos.

What is a bond?

Long-term borrowing instrument.

When is a bond selling at a premium?

Price above par value.

When is a bond selling at a discount?

Price below par value.

What are the three sources of bond return?

Coupon income, price appreciation, reinvestment income.

What are major bond risks?

Credit risk, price risk, reinvestment risk, call risk.

T-bills

Short-term U.S. government debt securities sold at a discount and maturing in one year or less.

How do T-bills generate return?

Bought below face value and paid full value at maturity.

What is a certificate of deposit?

A time deposit at a bank that pays interest and has a fixed maturity date.

What is commercial paper?

Short-term unsecured debt issued by corporations to finance operations.

Why do firms issue commercial paper?

To raise short-term funding without bank loans.

What is a banker’s acceptance?

A short-term loan guaranteed by a bank, commonly used in international trade.

Why are banker’s acceptances considered safe?

Because the bank guarantees payment.

What are Eurodollars?

U.S. dollar deposits held in banks outside the United States.

Why are Eurodollars important?

They form a large international dollar lending market.

What is a repurchase agreement (repo)?

A short-term loan where securities are sold with an agreement to repurchase them later at a higher price.

What acts as collateral in a repo?

Usually government securities.

What are federal funds?

Overnight loans between banks of reserves held at the Federal Reserve.

What is the federal funds rate?

The interest rate banks charge each other for these overnight loans.

What are brokers’ calls?

Loans brokers obtain from banks to finance customers’ margin accounts.

Why are they called “call” loans?

The lender can demand repayment at any time.

What is LIBOR?

A benchmark interest rate at which major banks lend to each other in international markets.

Why is LIBOR important?

It’s used as a reference rate for many global loans and securities.

What is the call money rate?

The interest rate charged on very short-term loans that can be demanded back at any time, usually used for loans brokers take from banks to finance margin trading.

What are Treasury notes (T-notes)?

U.S. government bonds with maturities between about 2 and 10 years that pay interest periodically.

What are Treasury bonds (T-bonds)?

Long-term U.S. government bonds with maturities over 10 years (often 20–30 years).

What are Treasury Inflation-Protected Securities (TIPS)?

Government bonds whose principal is adjusted for inflation.

Why are TIPS valuable?

They protect investors from inflation risk.

What is federal agency debt?

Bonds issued by government-sponsored agencies (like Fannie Mae or Freddie Mac).

What are international bonds?

Bonds issued by foreign governments or companies, often in global markets.

What are municipal bonds?

Bonds issued by state or local governments to fund public projects.

What are corporate bonds?

Bonds issued by companies to raise financing.

What is a mortgage-backed security (MBS)?

A bond backed by a pool of home mortgages.

Realized yield

the actual return earned during the holding period for an investment, and it may include dividends, interest payments, and other cash distributions.

What is price appreciation in bonds?

The increase in the bond’s market price over time.

When does bond price appreciation occur?

When interest rates fall or when a discount bond moves toward par value.

What is coupon income?

The periodic interest payments received from a bond.

Why is coupon income considered predictable?

Because payments are fixed in the bond contract.

What is reinvestment income?

Income earned from reinvesting coupon payments.

Why is reinvestment income uncertain?

It depends on future interest rates.

Convexity

A measure of how the bond’s price sensitivity to interest rate changes itself changes as rates move.

What is credit risk in bonds?

The risk that the issuer may fail to make interest or principal payments.

Which bonds usually have the lowest credit risk?

U.S. Treasury bonds.

What is price risk?

The risk that a bond’s market price will change due to interest rate movements.

What happens to bond prices when interest rates rise?

Bond prices fall.

What is reinvestment risk?

The risk that coupon payments must be reinvested at lower interest rates.

When is reinvestment risk highest?

When interest rates fall.

What is call risk?

The risk that the issuer redeems (calls) the bond before maturity.

When are bonds most likely to be called?

When interest rates fall.

Why is call risk bad for investors?

They must reinvest at lower rates.

Preferred stock

Hybrid investment

Dividends paid on steady basis

Senior security

American Depository Receipts (ADRs)

Certificates representing ownership in shares of a foreign company

What is a derivative instrument?

A financial security whose value depends on the value of another asset (like a stock, bond, or commodity)

What is a call option?

A contract giving the holder the right to buy an asset at a fixed price before a certain date.

When do investors buy call options?

When they expect the asset price to rise.

What is a put option?

A contract giving the holder the right to sell an asset at a fixed price before a certain date.

When do investors buy put options?

When they expect the asset price to fall.

What is a futures contract?

An agreement to buy or sell an asset at a predetermined price on a future date.

What is the futures price?

The agreed-upon price at which the asset will be bought or sold in the future.

What does it mean to take a long position in a futures contract?

Agreeing to buy the asset in the future.

What does it mean to take a short position in a futures contract?

Agreeing to sell the asset in the future.

What is the forward price-to-earnings (P/E) ratio?

A valuation ratio that compares a stock’s current price to its expected future earnings.

What is the primary market?

The market where new securities are issued and sold to investors.