FI 302 Exam 2 - Whaley

What is a Bond?

- long term debt instruments
- provide periodic interest income - annuity series
- return of the principal amount at maturity

Components of a Bond

Par Value, Coupon Rate, Coupon, Maturity Date, Yield to Maturity

Par Value

typically $1,000

Coupon Rate

-Annual rate of interest paid
-Set by the company at the time of issue and is fixed

Coupon

Regular interest payment received by holder per year

Maturity Date

Expiration date of bond when par value is paid back

Yield to Maturity

-Expected rate of return based on price of bond
-Dependent on market, economic, and company-specific factors and is therefor variable

Bond Pricing (4 steps)

1. Lay out the timing and amount of the cash flows promised
2. Determine the appropriate discount rate for the cash flows
3. Find the present value of the lump-sum principal and the annuity stream of coupons
4. Add the present value of the lump-sum principal and the present value of the coupons to get the price or value of the bond

Most corporate and government bond pay coupons on a _________

semiannual basis

Zero-Coupon Bonds

-Known as "pure" discount bonds and sold at a discount from face value
-Do not pay any investor over the life of the bond

A bond's coupon rate differs from its ________

Yield to Maturity (YTM)

Premium Bond

Coupon Rate > YTM
Price > par value

Par Value Bond

Coupon Rate = YTM
Price = par value

Discount Bond

Coupon Rate < YTM
Price < par value

Callable bonds

A bond that can be redeemed by the issuer prior to its maturity. If interest
rates have declined since the company first issued the bond, the company is likely to want to
refinance this debt at the lower rate of interest.

When interest rates go ______, bond prices _______

Rates go UP
Prices FALL

Bond Ratings

-Ratings are produced by Moody's, Standard and Poor's, and Fitch (gauge likelihood of default by issuer)
-Assisting issuing companies establish a yield on newly issued bonds

Junk Bonds

-the label given to bonds that are rated below BBB
-considered to be speculative in nature and carry higher yields than those rated BBB or above

Fallen Angels

the label given to bonds that have their ratings lowered from investment to speculative grade

US Government Bonds

-Includes bills, notes, and bonds sold by the Department of the Treasury

Treasury Bills

-zero-coupon, pure discount securities with maturities ranging from 1,3, and 6 months up to 1 year

Treasury Notes

between 2-10 year maturities

Treasury Bonds

have greater than 10-year maturities, when first issued

Characteristics of Stocks

-major financing vehicle for corporations
-provides holders with an opportunity to share in the future cash flows of the issuer
-holders have ownership in the company
-no maturity date and variable periodic income

Stock Ownership

-share in the residual profits of the company

Stock Voting Rights

-participate in the management of the company
-elect the board of directors which selects the management team that runs the company's day to day operations

Standard Voting Rights

Typically one vote per share provided to shareholders to vote in board elections and other key changes to the charter and bylaws

Non-Voting Stocks

usually a temporary period of time

Super Voting Stocks

provide the holders with multiple votes per share, increasing their influence and control over the company

Dividends

Companies pay cash dividends periodically to their shareholders out of net income

Primary Markets

-First sale, first issue
-Initial Public Offering (IPO)
-Firm commitment vs best efforts

Secondary Market

-the "used" market, what you typically think of as the stock market
-NYSE, AMEX, NASDAQ

Valuation is more of an _____ than a science

art

Value of a share of stock equals the present value of its expected future cash flow...

-cash dividends paid (if any)
-future selling price of the stock
-the discount rate (risk-appropriate rate of return to be earned on the investment)

Constant Dividend Model with an Infinite Horizon

Assumes that the firm is paying the same dividend amount forever...and ever...in perpetuity
-Preferred Stock

Constant Dividend Model with an Finite Horizon

-assumes that the stock is held for a finite period of time and then sold to another investor
-constant dividends received over investment horizon

Constant Growth Dividend Model with an Infinite Horizon

-Known as Gordon Model (after Myron Gordon)
-Estimate is based on the discounted value of an invite stream of future dividends that grow at a constant rate

Constant Growth Dividend Model with an Finite Horizon

-investor expects to hold a stock for a limited number of years
-companys dividends are growing at a constant rate

Dividend Model Shortcomings

Need future cash flow estimates and a required rate of return, therefore difficult to apply universally.
• Erratic dividend patterns
• Long periods of no dividends
• Declining dividend trends

Preferred Stock

-pays constant dividend as long as the stock is outstanding
-typically has infinite maturity
-has "preferred" status over common stockholders in the case of dividend payments and liquidation payouts
-dividends can be cumulative or non-cumulative

Efficient Market

-market in which security prices are current and fair to all traders
-transaction costs are minimal

Two Forms of Efficiency

-Operational
-Informational

Operational Efficiency

-Speed and accuracy with which trades are processed.
-Match buyers and sellers very efficiently and at the best available price

Informational Efficiency

-Speed and accuracy with which information is reflected in the available prices for trading.
-Securities would always trade at their fair or equilibrium value with diverse information
-These three forms make up what is known as the efficient market hypothesis (EMH)

Weak-form efficient markets

Current prices reflect past prices and trading volume.

Semi-strong-form efficient markets

• Current prices reflect price and volume information and all available relevant public information as well.
• Publicly available news or financial statement information not very useful.

Strong-form efficient markets

• Current prices reflect price and volume history of the stock, all publicly available information, and even all private information.
• All information is already embedded in the price--no advantage to using insider information to routinely outperform the market.

Rates of Return

Performance analysis of an investment requires investors to measure returns over time

Holding Period to Annual Return

With varying holding periods, holding period returns not good for comparison

Risk (Certainty and Uncertainty)

• Future performance of most investments is uncertain. • Risky implies not only the potential for loss but also for
uncertain gain (risk does not take sides)
• It is important to measure and analyze the risk potential of an investment, so as to make an informed decision.

Risk can be defined as....

a measure of the uncertainty in a set of potential outcomes for an event in which there is a chance of some loss.

Variance and Standard Deviation are measures of....

dispersion

The larger the variance....

the greater is the variability and hence the riskiness of a set of values

Investment rule number 1

If faced with 2 investment choices having the same expected returns, select the one with the lower expected risk.

Investment rule number 2

If two investment choices have similar risk profiles, select the one with the higher expected return.

Risk and Return Trade Off

• Maximize return, minimize risk
• Historically, higher expected returns are accompanied by greater variances. The investor's tolerance for and attitude towards risk matters.
• Diversification is the key!

Diversification is the....

the spreading of wealth over a variety of investment opportunities so as to eliminate some risk

By dividing up one's investments across _______________________ , companies, industries, and countries, it is possible to considerably reduce one's exposure to risk.

many relatively low-correlated assets

Diversification Benefit

Increase the negative correlation between 2 stocks, increase the reduction in risk achieved by adding it to the portfolio

Unsystematic or Diversifiable risk

• Sometimes called idiosyncratic risk
• Related to asset (company) specific events/uncertainty (i.e.
product or labor problems)

Systematic or Non-diversifiable risk

• Sometimes called market risk
• Recession or inflation

Well-diversified portfolio

one whose unsystematic risk has
been completely eliminated

Beta

measures volatility of an individual security against the market as a whole. (measure of an assets systematic risk)

Average beta = 1.0

Market beta

Beta < 1.0

less risky than the market e.g. utility stocks

Beta > 1.0

more risky than the market e.g. high-tech stocks

Beta = 0

independent of the market e.g. T-bill

Standard deviation

measure of the total risk of an asset, both its systematic and unsystematic risk.

If an asset is part of a well-diversified portfolio use....

beta

If we do not have a well-diversified portfolio, it is more use....

standard deviation

The Security Market Line

shows the relationship between an asset's required rate of return and its systematic risk measure

SML 3 Assumptions

1. There is a basic reward for waiting: the risk-free rate
2. Investors expect to be proportionately compensated for bearing risk.
3. There is a consistent trade-off between risk and reward at all levels of risk. As risk doubles, so does the required rate of return, and vice-versa.

The Capital Asset Pricing Model

-the equation form of the SML
-Used to quantify the relationship between expected rate of return and systematic risk.

(CAPM) It states that the expected return of an investment is a function of:

function of:
1. The time value of money (the reward for waiting)
2. A reward for taking on risk
3. The amount of risk