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What is a bond?
A long term debt instrument in which a borrower promises to pay back the principal with interest on specific dates in the future.
Par Value
The principal amount to be repaid at the maturity of the bond.
Coupon rate
The interest rate for bond coupons, expressed in annual percentage terms.
Maturity date
The expiration date of the bond on which the final interest payment is made as well as the principal repayment.
Coupon
The regular interest payment of the bond
Yield to Maturity (YTM)
Discount rate for which the present value of the bond’s payments equals the price. The expected rate of return on a bond if held to maturity.
Ordinary annuity
Payment is due at the end of each period. Less risky because you have a longer amount of time to make payments. Ex: Mortgage and loan payments.
Annuity due
Payment is due at the beginning of each period. Riskier as you must make payments immediately. Ex: rent and insurance payments.
Perpetuity
A type of annuity in which payments are set up to never end.
Annuity
Level stream of cash flows at regular intervals with a finite maturity.
Amortization
Repaying a loan or debt via an annuity cash flow.
Why is amoritization good for lenders?
There is no uncertainty in the cash flow from a loan.
Why is amortization good for borrowers?
It provides a regularly scheduled payment.
Effective annual rate (EAR)
The true rate of return to the lender and the true cost to the borrower. Takes compounding into account.
Annual Percentage Rate (APR)
The most common rate quoted by financial institutions. Interest rate annualized in the US using simple interest.
Characteristics of stock
Major financing vehicle for corporations. Provides holders an opportunity to share in the future cash flows of the issuer. Holders has “ownership” in the company (residual claim on profit). No maturity date and variable periodic income.
Primary or Initial public offering (IPO)
The first issuing or selling of a stock.
Secondary market
Market in which securities are traded among investors.
Common stock
First sold in the primary market, then traded among investors, may or may not issue a dividend, and frequently carry voting rights regarding the board of directors.
Dividends
Payment by a company to its stockholders. Shareholders must pay taxes on dividends they receive.
Voting rights
Comes with common stock. The owner of the stock has a vote regarding charters, bylaws, and the board of directors.
Face value
Payment at maturity of the bond.
Super voting common stock
Stock owners have multiple votes per share.
Book Value
Net worth of the firms equity according to the balance sheet. The historical value.
Liquidation Value
Net proceeds that could be realized by selling the firms assets and paying off its creditors (debt holders).
Market Value
Based upon the current pricing of security. What the value could be in the future.
Bid price
The prices in which investors are willing to buy shares.
Ask price
The price at which current shareholders are willing to sell their shares.
What drives a wedge between market and book value?
Extra earning power, intangible assets (hard for book value to account for intangible assets), and future investments.
Market orders
Instructs a trader to execute a trade at the best available price as soon as possible.
Limit orders
Meant to specify the price at which an investor is willing to buy or sell. Set the maximum or minimum price at which you are willing to complete a transaction.
Yield curve
A plot of the relationship between bond YTM and time to maturity. ◦ Typically drawn using bonds of the same kind (coupon rate) and issuer. The slope of the yield curve allows bond traders to speculate on future bond prices (by using the bond return)
Default risk
Involves the bond issuer not paying on its bond obligations (either coupon payments or face value). The risk that a bond issuer may default on his bonds.
Default premium
The difference between the return on federal bonds (safe) and corporate bonds (risky). The additional yield on a bond that investors require for bearing default risk.
Bond ratings
Rating the likelihood of a bonds default. Provide insight into the bonds risks.
An investment grade bond
Has a moodys rating of Baa or above and Standard and Poors rating of BBB or above.
Dividend discount model (DDM)
The current value of the stock equals the present value of all expected future dividends
coupon rate and what it tells you about the bond.
Bonds priced above face value is a premium. A bond sold below face value is a discount.
Interest rate risk
A change in interest rate effects long term bonds more than short term bonds.
Secured debt
debt that, in the event of a default, has first claim on specified assets.
Protective covenants
Conditions imposed on borrowers to protect lenders from unreasonable risks.
Semiannual coupon bond
Most corporate and gov bonds pay coupon on a semiannual basis.
Sustainable growth
The firms growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant
