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1

What implications can financial managers/financial analysts/investors/economists get from observing the yield curve?

For financial managers – determine costs of funding, i.e., what term of funds is relatively cheaper to get.

The yield curve can be regarded as an indicator for the future market and economy, giving investors either an optimistic or a pessimistic view or forecasting about the future economy.

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Market Segmentation Theory

Theory suggesting that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment

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Liquidity Preference Theory

Theory suggesting that long-term rates are generally higher than short-term rates because investors perceive short-term investments as more liquid and less risky than long-term investments

Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities

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Expectations Theory

The theory that the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward-sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve.

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Theories of the Term Structure

Expectations Theory

Liquidity Preference Theory

Market Segmentation Theory

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Flat Yield Curve

Interest rates do not vary much at different maturities.

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Inverted Yield Curve

Downward-sloping

Long-term interest rates are lower than short-term interest rates.

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Normal Yield Curve

Upward-sloping

Long-term interest rates are generally higher than short-term rates.

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Types of Yield Curve

Normal Yield Curve

Inverted Yield Curve

Flat Yield Curve

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Yield Curve

A graphic depiction of the term structure of interest rates at a particular time projecting required returns on different terms of maturities of bonds.

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Risk-Free Rate (Rf)

The return on this investment is not affected by delinquency or default risk.

i.e., Completely free of risk, but it is still affected by inflation or expected inflation rate.

U.S. T-Bill is a common proxy for the risk-free rate.

Thus = r* + i

U.S. T-Bill is a common proxy for the risk-free rate.

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Risk Premium

Nominal interest rates are also affected by risk. Investors demand a higher nominal rate of return on risky investments.

The associated risk adds additional “price” upon the specific investment (j).

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Nominal and Real Interest Rate Formulas

(1+r) = (1+ r*)

(1+i)r* = r – i, or r = r* + i

Where:

r = nominal int rate,

r* = real int rate, and

i = expected inflation rate

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What factors influence Interest Rate?

Inflation or expected inflation,

Risk,

Liquidity Preference

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Contractionary Monetary Policy

Decreases money supply by increasing the interest rate.

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Expansionary Monetary Policy

Increases money supply by lowering the interest rate.

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Federal Reserve Monetary Policy Tools

Open market operation,

Reserve Requirement Rate,

Discount rate.

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_____ & ______ of fund in the entire economy determine an equilibrium interest rate.

Supply & Demand

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Expected Returns

A forward-looking perspective on the return or interest.

i.e., What return should we expect the investment to provide in the future given its risk?

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Interest Rate

Also known as Required Return.

Represents the “cost of money”.

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Wealth maximization as a goal of the firm involves increasing the wealth of whom?

Shareholders.

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As the risk of a stock decreases, the required rate of return will _______

Decrease.

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Role of Time Value in Finance

The Time Value of Money refers to the idea that it is better to have money sooner than later.

Money invested today could bring a higher rate of return than money invested tomorrow, making it more valuable.

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Compounding

A technique used to find the future value of each cash flow at the end of an investment’s life, then it sums these values to find the investment’s future value.

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Discounting

A technique used to find the present value of each cash flow at time zero and then sums up these values to find the investment’s values today.

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Single Amount Cash Flow

A lump sum amount either currently held or expected at some future date.

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Annuity Cash Flow

A stream of equal periodic stream of cash flows over a specified time period.

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Mixed Stream Cash Flow

A stream of unequal periodic cash flows that reflect no particular pattern.

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Future Value

The value on some future date of money that you invest today.

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Effect of Interest Rate on Future Value

The higher the interest rate, the higher the future value.

The longer the money remains invested, the higher the future value.

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Simple Interest

Interest that is earned only on an investment’s original principal (amount of money on which interest is paid) and not accumulated on interest.

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Compound Interest

Interest that is earned on a given deposit and has become part of the principal at the end of a specified period

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Present Value

The value, in today’s dollars, of some future cash flow.

Annual rate of return on Present Value is known as he “Discount Rate”.

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Effect of Interest Rate on Present Value

The higher the discount rate, the lower the present value.

The longer the waiting period, the lower the present value.

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Ordinary Annuity

An annuity for which the cash flow occurs at the ** END **of a period

When solving on calculator, set “PMT” to “END” mode.

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Annuity Due

An annuity due for which the cash flow occurs at the ** BEGINNING **of a period.

When solving on calculator, set “PMT” to “BEGIN” mode.

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Comparison of Annuity Due vs. Ordinary Annuity

The FV (Future Value) of an annuity due is always greater than the FV of an otherwise identical ordinary annuity.

The PV (Present Value) of an annuity due is always greater than the PV of an otherwise identical ordinary annuity.

FV or PV of an annuity due is (1+

*r*) times greater than that of an ordinary annuity respectively.“

*r*” represents the interest rate per period.Represented in decimal format:

i.e., 4% is equivalent to .04.

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Perpetuity

An annuity with an infinite life providing continual annual cash flow.

NO FV can be calculated or specified for perpetuity.

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Formula for Present Value of Perpetuity

PV = CF / r

Where:

PV represents “Present Value”

CF represents “Total Cash Flow”

*r*represents “Interest rate per period”

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Present Value, Future Value of a Mixed Stream

There is no mathematical equation to express the PV or FV of a mixed stream cash flow.

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Nominal (Stated) Interest Rate

Contractual annual rate of interest that is charged by a lender or promised by a borrower.

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Effective (True) annual rate (EAR)

The annual rate of interest actually paid or earned.

Reflects the effects of compounding frequency, whereas nominal does not.

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Municipal Bond

A bond issued by a state or local government body.

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Corporate Bond

A long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms.

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Par Value, Face Value, Principal

The amount of money the borrower must repay at maturity,and the value on which periodic interest payments are based.

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Coupon Rate

The percentage of a bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest.

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Bond Indenture

A legal document that specifies both the rights of the bondholders and the duties of the issuing corporation.

Maintain satisfactory accounting records.

Periodically supply audited financial statements.

Pay taxed and other liabilities when due.

Maintain all facilities in good working order.

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Standard Debt Provisions

Provisions in a bond indenture specifying certain record-keeping and general business practice that the bond issuer must follow.

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Restrictive Covenants

Provisions in a bond indenture that place operating and financial constraints on the borrower, including:

Place limits on the values of certain accounting ratios that must be maintained while the debt is outstanding.

Prohibit or limit the sale of accounts receivable or other assets to generate cash.

Impose fixed-asset restrictions.

Constrain subsequent borrowing.

Limit the annual cash dividend payments to a specified percentage or amount.

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Subordination

The stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

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Sinking-Fund Requirement

A restrictive provision in the systematic requirement of bonds prior to their maturity.

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Collateral

A specific (physical or financial) asset against which bondholders have a claim in the event that a borrower defaults on a bond.

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Secured Bond

A bond that is backed by some form of collateral.

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Unsecured Bond

A bond backed only by the borrower’s ability to repay the debt (not backed by any type of collateral)

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Trustee

A paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated.

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Major Factors that affect cost (Coupon Rate)

Impact of bond maturity, the longer the maturity of a bond, the more sensitive the price of the bond will be to future changes in the interest rates.

The impact of offering is two-fold:

A bond flotation and admin costs per dollar borrowed (fixed average cost) are likely to decrease as offering size increases, however

Larger offerings result in greater risk of default which may increase the interest of bonds.

Impact of the issuer’s risk, the greater the issuer’s default risk, the higher the interest rate.

Impact of the cost of money, the prevailed market interest rate level.

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Conversion Feature

A feature of convertible bonds that allows bondholders to change each bond into a stated number of shares of common stock.

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Call feature

Gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity.

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Call Price

The stated price at which a bond may be repurchased.

As a rule, the call price exceeds the par value of the bond by any amount equal to one year’s interest.

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Call Premium

The amount by which a bond’s call price exceeds its par value.

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Stock Purchase Warrants

A financial option type of instruments that give its holders the right to purchase a certain number of shares of the issuer’s common stock at a specified price over a certain period of time.

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Current Yield (Bond Yield)

A measure of a bond’s cash returns for the year; calculated by dividing the bond’s annual interest payment by its current price.

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Bond Ratings

Independent agencies such as Moody’s, Fitch, and Standard & Poor’s assess the riskiness of publicly traded bond issues, investment grade, and speculative bonds.

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Traditional Types of Bonds

Debentures, Subordinated Debentures, Income Bonds, Mortgage Bonds, Collateral Trust Bonds, and Equipment Trust Certificates

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Contemporary Types of Bonds

Zero Coupon Bonds, Junk Bonds, Floating-Rate Bonds, Extendible Notes, and Putable Notes.

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Debentures

Unsecured bonds that only creditworthy firms can issue. Convertible bonds are normally debentures.

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Subordinated Debentures

Subordinated debentures claims are not satisfied until those of the creditors holding certain (senior) debts have been fully satisfied.

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Income Bonds

Payment of interest is required only when earnings are available. Commonly issued in the reorganization of a failing firm.

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Mortgage Bonds

Secured by real estate or buildings.

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Collateral Trust Bonds

Secured by stock and (or) bonds that are owned by the issuer. Collateral value is generally 25% to 35% greater than bond value.

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Equipment Trust Certificates

Used to finance “rolling stock,” such as airplanes, trucks, boats, and railroad cars. A trustee buys the asset with funds raised through the sale of trust certificates and then leases it to the firm; after making the final scheduled lease payment, the firm receives title to the asset. A type of leasing.

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Zero Coupon Bonds

Issued with no (zero) or a very low coupon (stated interest) rate and sold at a large discount from par. A significant portion (or all) of the investor’s return comes from a gain in value (i.e., par value minus purchase price). Generally callable at par value.

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Junk Bonds

Debt rated Ba or lower by Moody’s or BB or lower by Standard & Poor’s. Commonly used by rapidly growing firms to obtain growth capital, most often as a way to finance mergers and takeovers. High-risk bonds with high yields, often yielding 2% to 3% more than the best-quality corporate debt.

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Floating-Rate Bonds

The stated interest rate is adjusted periodically within stated limits in response to changes in specified money market or capital market rates. Popular when future inflation and interest rates are uncertain. Tend to sell at close to par because of the automatic adjustment to changing market conditions. Some issues provide for annual redemption at par at the option of the bondholder.

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Extendible Notes

Short maturities, typically 1 to 5 years, that can be renewed for a similar period at the option of holders. Similar to a floating-rate bond. An issue might be a series of 3-year renewable notes over a period of 15 years; every 3 years, the notes could be extended for another 3 years, at a new rate competitive with market interest rates at the time of renewal.

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Putable Bonds

Bonds that can be redeemed at par (typically, $1,000) at the option of their holder either at specific dates after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions, such as being acquired, acquiring another company, or issuing a large amount of additional debt. In return for its conferring the right to “put the bond” at specified times or when the firm takes certain actions, the bond’s yield is lower than that of a non-putable bond.

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Eurobond

A bond issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denominated.

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Foreign Bond

A bond that is issued by a foreign corporation or government and is denominated in the investor’s home currency and sold in the investor’s home market.

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Debt

All borrowing incurred by a firm (creditors or bondholders) is repaid according to a fixed schedule of payments.

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Equity

Funds provided by the firm’s owners (investors or stockholders) that are repaid subject to the firm’s performance.

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Key Differences between Debt and Equity

Voice in Management

Debt, No.

Equity, Yes.

Claims on Income and Assets

Debt, Senior to equity.

Equity, Subordinate to debt.

Maturity

Debt, Stated in indenture.

Equity, None.

Tax Treatment

Debt, Interest deduction.

Equity, No deduction.

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Privately Owned Common Stock

The common stock of a firm is owned by private investors; the stock is not publicly traded.

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Publicly Owned Common Stock

The common stock of a firm is owned by public investors; the stock is traded publicly.

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Closely Owned Common Stock

The common stock of a firm is owned by an individual or a small group of investors (such as family); they are usually privately owned companies.

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Widely Owned Common Stock

The common stock of a firm is owned by many unrelated individual and institutional investors.

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Par Value

An arbitrary value that is established for legal purposes in the firm’s corporate charter that can be used to find the total number of shares outstanding by dividing it into the book value of common stock.

Number of Shares = Book Value of Common Stocks / Par Value

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Preemptive Rights

Allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued.

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Dilution of Ownership

A reduction in each previous shareholder’s fractional ownership resulting from the sale of new common shares.

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Dilution of Earnings

A reduction in each previous shareholder’s fractional claim on the firm’s earnings resulting from the sale of new common shares.

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Rights Offering

Allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their fractional ownership.

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Authorized Shares

A firm’s corporate charter (subject to the board of directors’ decision) allows it to issue.

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Outstanding Shares

Issued shares of common stock sold in stock markets and held by investors.

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Treasury Stock

Issued shares of common stock held by the firm; often these shares have been sold in stock markets and then repurchased by the firm.

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Issued Shares

Shares of common stock that have been put into circulation; the sum of outstanding shares and treasury stock.

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Voting Rights

Generally, each share of common stock entitles its holder to one vote in the election of directors and on special issues.

Votes are assignable and may be cast at the annual stockholders’ meeting.

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Supervoting Shares

Stock that carries with it multiple votes per share, rather than the single vote per share typically given on regular shares of common stock.

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Nonvoting Common Stock

No voting rights; issued when the firm wishes to raise capital through the sale of common stock but does not want to give up its voting control.

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Proxy Statement

A statement transferring the votes of a stockholder to another party.

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Proxy Battle

The attempt by a non-management group to gain control of the management of a firm by soliciting a sufficient number of proxy votes.

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Dividends

A portion of a company's earnings that is paid to a shareholder.

Not guaranteed to common stockholders, but they expect a similar payout based on past payment history.

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