Finance exam 2

What 4 factors affect the level of interest rates?

- Production opportunities

What is the relationship between the spread between the corporate and treasury yield curves and the corporate bond rate?

as the spread between the corporate and treasury yield curve increases or widens, the corporate con rate decreases

what is a bond?

A long-term debt instrument in which a borrower agrees to make payments of principal and *interest*, on specific dates, to the holders of the bond.

what are the 4 main types of bonds?

- US treasury bills/notes/bonds

- US corporate bonds

- municipal bonds

- foreign bonds: Govt./sovereign & corporate

what are the characteristics of a US treasury bill/note/bond?

- free of default risk

how do you differentiate between bills, notes & bonds?

bills \= less than 2 years to maturity

notes \= 2-10 years to maturity

bonds \= 10+ years to maturity

what are US corporate bonds?

default risk measured by credit rating.

higher risk means higher yield (rate of return) demanded by investors

what isa municipal bond?

issued by cities, counties & states

federal tax-free, state-tax free for residents of that state

what is a foreign bond?

issued by foreign governments or corporations

what type of risk do ALL bonds face?

price risk AKA interest rate risk

what is price/interest rate risk?

if market yields go up, prices go down (vice versa)

what bonds are the ONLY bonds that do not face default risk?

treasury bonds

what type of risk do foreign bonds face?

*currency risk*

default risk

price risk

who owns and trades most bonds?

large financial institutions

What is par value (FV)?

the face value of the bond, which is paid at maturity

what is the coupon interest rate? (PMT)

stated interest rate (generally fixed) paid by the issuer

what is the maturity date? (N)

time periods until the bond must be repaid (annual or semi-annual typically)

what is the issue date?

the date when the bond was issued

what is the yield to maturity (I/YR)? (YTM or rd)

rate of return earned on a bond held until maturity

What is the opportunity cost of debt capital?

The discount rate (ri) is the opportunity cost of capital, and is *the rate that could be earned on alternative investments of equal risk.*

what is the relationship between price risk and YTM?

as YTM increases, so does price risk

what is reinvestment risk?

the concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income

what happens if an issuer defaults?

investors receive less than the promised return SO

expected return on corporate & municipal bonds is less than the promised return

what is default risk influenced by?

the issuer's financial strength

the terms of the bond contract

what are the 5 types of corporate bonds?

- mortgage bonds

- debentures

- subordinated debentures

- investment grade bonds

- junk bonds

what is a mortgage bond?

bonds that pledge a specific asset as collateral

what is a debenture?

bond with no specific collateral

what is a subordinated debenture?

a debenture that gets paid after all other debt claims are paid for that period

What are bond ratings designated to do?

to reflect the probability of a bond issue going into default

what factors affect default risk & bond ratings?

- financial performance

- qualitative factors: bond contract terms

- misc. qualitative factors

what factors go into financial performance?

- debt ratio

- TIE ratio

- current ratio

what is in the bond contract terms?

- secured vs. unsecured debt

- senior vs. subordinated debt

- guarantee and sinking fund provisions

- debt maturity

what are the miscellaneous qualitative factors affecting default risk?

- earnings stability

- regulatory environment

- potential antitrust or product liabilities

- pension liabilities

- potential labor problems

what is a coupon?

periodic interest payments from a bond

when is the principal of a loan paid back?

on the maturity date

how do you express a coupon payment?

as a percent age of the principal amount

are coupon payments fixed?

YES \-- they are an annuity

when will YTM be expressed as APR?

the bond has semi-annual coupons

what is the real risk free rate of interest?

the interest rate that would exist on a riskless security if no inflation were expected

what is the nominal risk-free rate?

the real risk-free rate plus a premium for expected inflation (IP)

what is the inflation premium (IP)?

the average expected inflation rate over the life of the security

what is the default risk premium (DRP)?

that additional return that an investor requires due to the chance that the issuer will not make the promised interest or principal payments at the stated time.

what is the liquidity premium (LP)?

the additional return for those securities that cannot be converted into cash relatively quickly at a reasonable price.

what is the maturity risk premium (MRP)?

the additional return required on securities that are longer term and are exposed to price declines due to increases in inflation and interest rates

Which type of security has lower interest rates? (short-term or long-term)

SHORT TERM

will the yield curve of a treasury security ever be higher than that of a corporate security?

NO

When does the spread between Corporate and Treasury yield curves widen?

the corporate bond rating decreases (equal when it is equal to DRP+LP)

what are the 2 types of investment risk?

- stand-alone risk

- portfolio risk

what is investment risk related to?

the probability of earning a low or negative actual return

what is a probability distribution?

a listing of all possible outcome & the probability of each occurrence

what % will the T-bill return independent of the economy?

5.5%

do T-bills promise a completely risk-free return?

NO

- still exposed to inflation (although very little unexpected inflation is likely to occur over such a short period of time)

- risky in terms of reinvestment

- risk-free in the default sense

How does the returns of High Tech behave in relation to the market?

moves with the economy (positive correlation) this is typical

how do collections behave in relation to the market?

it is countercyclical with the economy (negative correlation)

this is unusual

what does standard deviation measure?

total/stand-alone risk

what is the relationship between the standard deviation and the probability that actual returns will be close to expected returns?

the larger the standard deviation, the lower the probability that actual returns will be close to expected returns

what is the coefficient of variation?

a standardized measure of dispersion about the expected value, that shows the risk per unit of return

what does risk aversion assume?

assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities

what is risk premium?

the difference between the return on a risky asset and a risk-less asset, which serves as compensation for investors to hold riskier securities

what is a portfolio's expected return?

a weighted average of the returns of the portfolio's component assets

How can a portfolio provide the average return of its component stocks but lower than average risk?

negative correlation between stocks

what is the average risk for a stock?

standard deviation \= 35%

what decreases as stocks are added to a portfolio?

Risk (standard deviation)

what remains constant as you add more stocks to a portfolio?

expected return

when does the diversification benefits of adding stocks go away?

after about 40 stocks

risk tends to converge to 20%

what is market risk?

portion of a security's stand-alone risk that cannot be eliminated through diversification. (BETA)

what is diversifiable risk?

portion of a security's stand-alone risk that can be eliminated through proper diversification