Finance Exam 2

Bond

A long-term debt instrument where a borrower (issuer) agrees to make payments of principal and interest on specific dates to the holder.

Face Value (Par Value)

The principal amount of a bond repaid at the end of the term, usually $1,000 for corporate bonds.

Coupon Interest Rate

The stated fixed interest rate paid by the issuer, multiplied by the par value to determine the dollar payment

Maturity

The specified date on which the principal amount (face value) is paid.

Yield to Maturity (YTM)

The bond’s promised rate of return if held until maturity. It is the market interest rate for bonds with similar features.

Interpretation

YTM represents the average return if held to maturity, assuming all coupons are reinvested at the same rate.

Current Yield

Calculated as the Change in Price / Beginning Price It only considers the coupon portion of the return

Capital Gains Yield

Calculated as Change in Price/ Beginning Price

Yield to Call (YTC)

The expected rate of return on a callable bond if it is called before maturity.

Par Value Bond

A bond where the price equals the face value; this occurs when the Coupon Rate = YTM.

Discount Bond

A bond that sells for less than its face value; this occurs when the Coupon Rate < YTM

Premium Bond

A bond that sells for more than its face value; this occurs when the Coupon Rate > YTM.

Inverse Relationship

Bond prices and interest rates (yields) always move in opposite directions. If interest rates rise, bond prices fall.

Price Risk

The risk of a decline in a bond's price due to an increase in interest rates. It is higher for bonds with long maturities or low coupons.

Reinvestment Risk

The concern that interest rates will fall, forcing future cash flows to be reinvested at lower rates.

Actual Return vs. YTM

If market interest rates change after a bond is purchased, the actual return will differ from the YTM because coupons will be reinvested at the new market rates.

Falling rates

lead to a lower actual return than the initial YTM.

Rising rates

lead to a higher actual return than the initial YTM.

Call Provision

Allows the issuer to refund (retire) the bond before maturity, usually when interest rates have declined.

Rate of Return

The percentage gain or loss on an investment, calculated as the ending value minus the amount invested, divided by the amount invested.

Risk

The variance or volatility of results, often measured statistically using variance or standard deviation

Risk Aversion

The concept that investors dislike risk and therefore require higher rates of return as an inducement to buy riskier securities.

Risk Premium (RP)

The difference between the expected rate of return on a risky asset and a less risky (or riskless) asset, serving as compensation for the added risk.

Stand-alone Risk

The risk an investor faces when holding only one asset. It is the sum of market risk and diversifiable risk.

Portfolio Risk

The risk an investor faces when holding multiple assets.

Market Risk

The portion of a security's risk that cannot be eliminated through diversification; it is caused by macro factors like war or inflation and is measured by beta.

Diversifiable Risk

The portion of a security's risk that can be eliminated by holding a portfolio of multiple stocks. It is caused by firm-specific events like lawsuits or strikes.

Standard Deviation ($\sigma$)

A statistical measure of the variability of a set of observations, used to measure total or stand-alone risk.

Expected Rate of Return

The rate of return expected to be realized from an investment, calculated as the weighted average of the probability distribution of possible results.

Coefficient of Variation (CV)

The standardized measure of risk per unit of return, calculated as the standard deviation divided by the expected return.

Correlation

The tendency of two variables to move together, measured by a coefficient ($\rho$) ranging from -1 to 1

Beta ($\beta$)

An indicator of a stock's volatility relative to the market. A beta of 1.0 means the security is as risky as the average stock, while a beta greater than 1.0 is riskier than average

Capital Asset Pricing Model (CAPM)

A model linking risk and required returns through the Security Market Line equation.

Security Market Line (SML)

The linear relationship between an asset's required return and its systematic risk (beta).