Mizzou Finance 3000 Exam 2

Annuity

Level set of frequent cash flows

Perpetuity

Type of annuity with a stream of level cash flows that are paid forever

Consols

(consolidated stock), name given to certain British government bonds (gilts) in the form of perpetual bonds redeemable at the option of the government

Annuity Due

An annuity in which the cash flows occur at the beginning of each period. All cash flows compound one more year than the ordinary annuity

Annual Percentage Rate (APR)

The interest rate per period times the number of periods in a year.

Effective Annual Rate (EAR)

An interest rate that reflects annualizing with compounding figured in

Amortized Loan

A loan structured for annuity payments that completely pay off the debt

Loan Principal

The amount of money that has been loaned, and is expected to be repaid to the lender.

Amortization Schedule

A schedule that illustrates the amortization of a bond discount or premium over the life of a bond.

Add-On Interest

Computes the amount of the interest payable at the beginning of the loan, which is then added to the principal of the loan

Financial Markets

Exist to manage the flow of funds from investors to borrowers as well as form one investor to another

2 dimensions that distinguish financial markets

1) Primary vs Secondary Markets. 2) Money vs Capital Markets

Primary Markets

Provide a forum in which demanders of funds (corporations like IBM or government entities like US Treasury) raise funds by issuing new financial instruments, such as stocks and bonds

Investment Banks

Financial institutions such as Morgan Stanley, Goldman Sachs, or Merrill Lynch that arrange most primary market transactions for businesses

Where does the initial (or primary market) sale of securities occur?

Either through a public offering or a s a private placement to a small group of investors

Initial Public Offerings (IPOs)

First time issuement of stocks and bonds

Secondary Markets

Stocks and bonds that are publicly traded after they are issued in primary markets. Examples include New York Stock Exchange and NASDAQ. Also trades financial instruments backed by mortgages and other assets, foreign exchange, and futures and options

Trading Volume

The number of shares of a security that are simultaneously bought and sold during a given period

Clearinghouse

A company whose stock trades on the exchange, runs on a for-profit basis

Money Markets

Feature debt securities or instruments with maturities of one year or less. Because they trade for only short periods of time, fluctuations in price are usually quite small

Over the Counter Markets (OTC)

Markets, especially most Money Markets, that do not trade in a specific location, but rather via telephones, wire transfers, and computer trading

5 types of Money Market instruments

1) Treasury Bills, 2) Federal funds and repurchase agreements, 3) Commercial Paper, 4) Negotiable certificates of deposit, 5) Banker's acceptances

Treasury Bills Definition

Short-term U.S. government obligations that command the highest dollar value of all money market instruments

Federal Funds Definition

Short-term funds transferred between financial institutions, usually for no more than one day

Repurchase Agreements (repos) Definition

Agreements involving security sales by one party to another, with the promise to reverse the transaction at a specified date and price, usually at a discounted price.

Commercial Paper Definition

Short-term unsecured promissory notes that companies issue to raise short-term cash (sometimes called paper)

Negotiable Certificates of Deposit Definition

Bank-issued time deposits that specify an interest rate and maturity date and are negotiable-traded on an exchange. Face value is usually at least $100,000

Bank Acceptances (BAs)

Bank-guaranteed time drafts payable to a vendor of goods

Capital Markets

Markets in which parties trade equity (stocks) and debt (bonds) instruments that mature in more than one year. Since they have longer maturities, they are subject to wider price fluctuations than are money market instruments

6 types of Capital Market Instruments

1) US Treasury notes and bonds. 2) US government agency bonds. 3) State and local government bonds. 4) Mortgages and mortgage-backed securities. 5) Corporate bonds. 6) Corporate Stocks

US Treasury Notes and Bonds Definition

Long-term obligations issued to finance the national debt and pay for other federal government expenditures

US Government Agency Bonds Definition

Long-term debt securities collateralized by a pool of assets and insured by agencies of the US government

State and local government bonds Definition

Debt securities issued by state and local (county, city, school) governments, usually to cover capital (long-term) improvements

Mortgages Definition

Long-term loans issued to individuals or businesses to purchase homes, pieces of land, or other real property

Mortgage-backed securities Definition

Long-term debt securities that offer expected principal and interest payments as collateral. These securities, made up of many mortgages, are gathered into a pool and are thus "backed" by promised principal and interest cash flows

Corporate Bonds Definition

Long-term debt securities issued by corporations

Corporate Stocks Definition

Long-term equity securities issued by public corporations; stock shares represent fundamental corporate ownership claims

Foreign Exchange Markets

Markets that trade currencies for immediate (aka "spot") or some future stated delivery.

Foreign Exchange Risk

Arises from the unknown value at which foreign currency cash flows can be converted into US dollars

Derivative Security

Financial security such as a futures contract, option contract, or mortgage-backed security that is linked to another, underlying security, such as a stock traded in capital markets or British pounds traded in foreign exchange markets. Generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future

Financial Institutions

(eg banks, thrifts, insurance companies, mutual funds) perform vital functions to securities markets of all sorts. Operate Financial Markets.

7 types of Financial Institutions

1) Commercial Banks. 2) Thrifts. 3) Insurance Companies. 4) Securities firms and investment banks. 5) Finance companies. 6) Mutual funds. 7) Pension funds

Commercial Banks Definition

Depository institutions whose major assets are loans and whose major liabilities are deposits. Bank loans cover a broader range, including consumer, commercial, and real estate loans, than do loans from other depository institutions. Also include more nondeposit sources of funds because of size and ability to access public securities markets

Thrifts Definition

Depository institutions including savings associations, savings banks, and credit unions. Tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Credit Unions operate on a not-for-profit basis for particular groups of individuals, such as a labor union or a particular company's employees

Insurance Companies Definition

Protect individuals and corporations from financially adverse events.

Securities Firms and Investment Banks Definition

Underwrite securities and engage in related activities such as securities brokerage, securities trading, and making markets in which securities trade

Finance Companies Definition

Make loans to both individuals and businesses. Do not accept deposits, but instead rely on short and long-term debt for funding, and many loans are collateralized with some kind of durable good such as washer/dryers, furniture, carpets, etc.

Mutual Funds Definition

Pool many individuals' and companies' financial resources and invest those resources in diversified asset portfolios

Pension Funds Definition

Offer savings plans through which fund participants accumulate savings during their working years. Participants then withdraw their pension resources (which have presumably earned additional returns in the interim) during retirement years. Funds originally invested/accumulated are exempt from current taxation. Participants don't pay taxes until after age 55, when tax brackets are lower

Direct Transfers Definition

Transfer of funds from fund suppliers to fund users

3 reasons that flowing funds would be lower without Financial Institutions

1) Fund Suppliers would have to continuously monitor their funds to make sure they are not being stolen or misused (Monitoring Costs). 2) Fund suppliers will want to keep more cash on hand since it is more liquidable. They may fear that they will not find anyone to purchase their financial claim and free up their funds (Liquidity Costs). 3) Fund suppliers face price risk when they buy securities-they may not get their principle back, or any return on their investment (Price Risk)

Price Risk Definition

The risk that an asset's sale price will be lower than its purchase price

How do Financial Institutions resolve Monitoring Cost?

They have a much greater incentive to collect information and monitor the ultimate fund user's actions, because the FI has far more at stake than any small individual fund supplier would have. The FI performs the necessary monitoring function via its own internal experts (Delegated Monitor)

How do Financial Institutions resolve Liquidity and Price Risk?

FIs act as Asset Transformers by purchasing the financial claims that fund user issue-primary securities such as mortgages, bonds, and stocks-and finance these purchases by selling financial claims to household investors and other fund suppliers as deposits, insurance policies or other Secondary Securities

Asset Transformers Definition

Service provided by financial institutions in which financial claims issued by an FI are more attractive to investors than the claims directly issued by corporations

Secondary Securities

Packages or pools of primary claims such as mortgages, bonds, and stocks

Shadow Banks

Nonfinancial service firms that perform banking services. Include Structured Investment Vehicles (SIVs), Special Purpose Vehicles (SPVs), Asset-Backed Commercial Paper (ABCP) conduits, limited-purpose finance companies, money market mutual funds (MMMFs) and credit hedge funds.

Nominal Interest Rates

Interest rates actually observed in financial markets

6 factors that influence nominal interest rates for individual securities

1) Inflation, 2) Real Risk-Free Rate, 3) Default Risk, 4) Liquidity Risk, 5) Special provisions regarding the use of funds raised by a particular security issuer, 6) The security's term to maturity

Inflation Definition

A continual increase in the price level of a basket of goods and services throughout the economy as a whole

Real Risk-Free Rate Definition

Risk-free rate adjusted for inflation; generally lower than nominal risk-free rates at any particular time

Default Risk Definition

Risk that a security issuer will miss an interest or principal payment or continue to miss such payments

Liquidity Risk Definition

Risk that a security cannot be sold at a price relatively close to its value with low transaction costs on short notice

Special Provisions Definition

Provisions (e.g., taxability, convertibility, and callability) that impact a security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions

Time to maturity Definition

Length of time until a security is repaid; used in debt securities as the date upon which the security holders get their principal back

Real Risk-Free Rate

The rate that a risk-free security would pay if no inflation were expected over its holding period (one year). Measurers only society's relative time preference for consuming today rather than tomorrow

Fisher Effect

Theorizes that nominal risk-free rates that we observe in financial markets must compensate investors for: 1) Any inflation-related reduction in purchasing power lost on funds lent or principal due. 2) An additional premium above the expected rate of inflation for forgoing present consumption (which reflects the real risk-free rate issue discussed previously)

Default Risk Premium

The difference between a quoted interest rate on a security and a Treasury security with similar maturity, liquidity, tax, and other features

Liquidity Risk

The risk that a security can not be sold at a predictable price with low transaction costs on short notice

Term Structure of Interest Rates/Yield Curve

Daily/Hourly changeability in interest rates

Three explanations for why the yield curve takes different shapes

1) Unbiased Expectations Theory. 2) Liquidity Premium Theory. 3) The Market Segmentation Theory

Unbiased Expectations Theory

At any given point in time, the yield curve reflects the market's current expectations of future short-term rates

Liquidity Premium Theory

Investors will hold long-term maturities only if these securities with longer term maturities are offered at a premium to compensate for future uncertainty in the security's value.

Market Segmentation Theory

Argues that individual investors and Fis have specific maturity preferences, and convincing them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium)

Forward Rate

An expected, or implied, rate on a short-term security that will originate at some point in the future