Finance: Interest Rates, Bonds, and Stock Valuation

Flashcards covering key concepts related to interest rates, bond valuation, and stock valuation.

Interest Rates

The cost of borrowing money, influenced by various determinants.

Determinants of Market Interest Rates Formula

r = r* + IP + DRP + LP + MRP, where each term symbolizes different risk premiums.

Inflation Premium (IP)

The average expected inflation over the bond's life.

Default Risk Premium (DRP)

The extra yield required by investors to compensate for default risk.

Liquidity Premium (LP)

Compensation for the risk of not being able to quickly convert an investment to cash.

Maturity Risk Premium (MRP)

Compensation for the risk of interest rates fluctuating over a longer investment period.

Normal Yield Curve

An upward sloping yield curve indicating long-term rates are higher than short-term rates, suggesting economic growth.

Inverted Yield Curve

A downward sloping yield curve indicating that short-term rates are higher than long-term rates, suggesting a possible economic slowdown.

Par Value of Bonds

The face value of a bond, typically $1,000.

Coupon Rate

The annual interest rate stated on a bond.

Call Provision

A feature allowing the issuer to redeem the bond before its maturity date.

Discount Bond

A bond that sells below par value, generally because the market interest rate is higher than the coupon rate.

Yield to Maturity (YTM)

Total expected return on a bond if held to maturity.

Current Yield

The annual coupon payment divided by the current price of the bond.

Proxy

An authorization for someone to vote on a shareholder's behalf.

Intrinsic Value of a Stock (V)

The true theoretical value of a stock based on expected future cash flows.

Discounted Dividend Model (DDM)

A method for valuating a stock based on the present value of expected future dividends.

Constant Growth Stock

A stock that pays dividends that are expected to grow at a constant rate.

Zero Growth Stock

A stock that pays a fixed dividend and does not expect growth.

Expected Rate of Return Model

The formula for expected return on a stock considering dividend yield and capital gains yield.

Preferred Stock Valuation

Determining the value of preferred stock based on its fixed dividend and required return.

Interest Rates

The cost of borrowing money, expressed as a percentage of the principal. They are influenced by various determinants such as inflation, risk, and the supply and demand for funds in the market.

Determinants of Market Interest Rates Formula

The formula r = r^{\ast} + IP + DRP + LP + MRP explains market interest rates. Here, r is the nominal interest rate, r^{\ast} is the real risk-free rate, IP is the inflation premium, DRP is the default risk premium, LP is the liquidity premium, and MRP is the maturity risk premium. Each term accounts for different risks and expectations.

Inflation Premium (IP)

The average rate of inflation expected over the life of a bond or loan. This premium is added to the real risk-free rate to compensate investors for the erosion of purchasing power due to rising prices.

Default Risk Premium (DRP)

The additional yield or interest rate investors demand to compensate them for the risk that the borrower may not make scheduled interest or principal payments. Higher perceived default risk leads to a higher DRP.

Liquidity Premium (LP)

An additional return required by investors for securities that cannot be quickly converted into cash at a fair market value. Assets that are less liquid carry a higher liquidity premium.

Maturity Risk Premium (MRP)

A premium that compensates investors for the risk of interest rate fluctuations over a longer investment period. Longer-term bonds are generally more sensitive to interest rate changes, thus typically requiring a higher MRP.

Normal Yield Curve

An upward-sloping yield curve where long-term interest rates are higher than short-term rates. This shape often indicates expectations of economic growth and/or higher inflation in the future.

Inverted Yield Curve

A downward-sloping yield curve where short-term interest rates are higher than long-term rates. This unusual shape often signals market expectations of an economic slowdown or recession in the near future.

Par Value of Bonds

Also known as face value or maturity value, this is the amount an investor receives when a bond matures. It is typically printed on the bond certificate, most commonly $$1,000 for corporate bonds.

Coupon Rate

The annual interest rate the bond issuer pays on the bond's par value. It is usually expressed as a percentage and determines the amount of the periodic coupon payments an investor will receive.

Call Provision

A feature in a bond indenture that allows the issuer to redeem (call) the bond before its scheduled maturity date, typically at a specified call price. This is often done if interest rates fall, allowing the issuer to refinance at a lower cost.

Discount Bond

A bond that is currently trading in the market at a price below its par value. This typically occurs when the market interest rate (yield to maturity) is higher than the bond's stated coupon rate.

Yield to Maturity (YTM)

The total return an investor can expect to receive if a bond is held until it matures. YTM takes into account the bond's current market price, par value, coupon interest rate, and time to maturity, effectively considering both coupon payments and any capital gains or losses.

Current Yield

A measure of a bond's annual income relative to its current market price. It is calculated by dividing the annual coupon payment by the bond's current market price. Unlike YTM, it does not consider capital gains or losses or the time value of money.

Proxy

A legal authorization given by a shareholder to another person (the proxy holder) to vote on their behalf at a company's shareholder meeting. This is common when shareholders cannot attend the meeting in person.

Intrinsic Value of a Stock (V)

The true and fundamental value of a company's stock, derived from all its expected future cash flows (e.g., dividends and eventual stock sale price), discounted back to the present. It represents what the stock should be worth, independent of its current market price.

Discounted Dividend Model (DDM)

A quantitative method used to estimate the intrinsic value of a stock based on the present value of all its future dividend payments. The dividends are discounted back to the present using an appropriate discount rate (required rate of return).

Constant Growth Stock

A stock whose dividends are expected to grow at a constant rate indefinitely into the future. This type of stock can be valued using the Gordon Growth Model, a specific application of the Discounted Dividend Model.

Zero Growth Stock

A stock that is expected to pay a constant, unchanging dividend amount forever, with no expectation of growth. It is valued as a perpetuity, where the stock's intrinsic value is the fixed annual dividend divided by the required rate of return.

Expected Rate of Return Model

The total return an investor expects to receive from a stock, composed of two parts: the dividend yield (annual dividends divided by the current stock price) and the capital gains yield (the expected percentage increase in the stock's price).

Preferred Stock Valuation

Preferred stock typically pays fixed, periodic dividends. Its valuation often treats these dividends as a perpetuity, meaning the value is calculated by dividing the fixed annual dividend by the investor's required rate of return for preferred stock.