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Bid-Ask Spread:
The difference between the bid price
and the asked price.
Ask price:
The price a dealer is willing to take for a security
Bid price
The price a dealer is willing to pay for a security
Bond markets
The trading volume in bonds on a typical day is many, many times larger than the trading volume in stocks.
• The largest securities market in the world in terms of trading volume is the U.S. Treasury market.
Term Structure of Interest Rates:
The relationship between nominal interest rates on default-free, pure
discount securities and time to maturity; that is, the pure time value of money.
• Tells us what nominal interest rates are on default-free, pure discount bonds of all maturities.
• Graphically, it is known as the yield curve.
Determinates of bond yields
When long-term rates are higher than short-term rates, the term structure is upward sloping.
• When long-term rates are lower than short-term rates, the term structure is downward sloping.
Common stock valuation
• Common stock is more difficult to value than bonds because:
• The cash flows are not known in advance
• The life of the investment is forever (no maturity)
• There is no way to easily observe the rate of return that the market requires
Common stock cash flows
• P0: the current price of the stock
• P1: the price of the stock in one period
• D1: the cash dividend paid at the end of one period
• R: the required return in the market on this investment
P0 = (D1 + P1)/(1 + R)
• Price of a stock is its present value today
• Future dividends plus ending value, discounted back
Zero growth
• If the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period
• The price of the stock is given by:
P0 = D/R
• The stock can be viewed as an ordinary perpetuity
• Present Value of a Perpetuity = Payment / Interest Rate
Dividend growth model
A model that determines the current price of a stock as it is dividend next period divided by the discount rate less the dividend growth rate
