Exam #3 - Finance

Bond

Publicly traded form of debt.
main way to raise capital
- a fixed-income security - make fixed payments
- issued to fund projects
- loan that requires regular interest payments and repayment of the principle

Indenture Agreement

a legal contract describing the bond characteristics and the bond holder and issuer rights
-par value
-time to maturity
-call to maturity
-coupon rate
-bond price

Bond Issuers

U.S. Treasury - safest fixed income bond
Corporate Bond - used to finance investments
Municipal bonds - issued by state and local government

Asset-backed Securities

debt securities who payments originate from other loans (credit card debt, auto loans, home equity loans)
known as a convertible bond - choose between par value and a specific number of shares
pay low interest

Premium bond

sells for a price greater than par

discount bond

sells for a price lower than par

How is the current price of a bond determined?

the present value of future cash flows discounted at the prevailing market interest rate

Zero Coupon Bond

a bond that is issued at a deep discount from its value at maturity and pays no interest during the life of the bond

Interest Rate Risk

the chance of a capital loss due to interest rate fluctuations

Reinvestment Rate Risk

the chance future interest payments will have to be reinvested at a lower interest rate

Current Yield

the bond's annual coupon rate divided by the bond's current market price

Yield to Maturity

reflects the total return the bond offers if purchased at the current price and held to maturity

Yield to Call

the total return that the bond offers if purchased at the current market price and held until the bond is called

Taxable equivalent yield

a modification to maturity compared to the return that corporate bonds and treasury securities offer

Credit Quality Risk

the chance that the issuer will not make timely interest payments or even default

Investment Grade Bonds

high credit quality corporate bonds

Junk Bonds

speculative bonds/high-yield bonds
low credit quality corporate bonds

Fixed-income securities are Blank______-term debt obligations.

longer

the bond market is ____ than the stock market.

larger

Bonds are____ and more____ than stocks and offer____ potential rewards and risks.

safer and more stable, higher rewards and risks

par value

assume to be $1000
the amount of the loan to be repaid
the principle of the bond

Time to Maturity

1 year to 30 years
the number of years left until maturity date

Call

allows issuer to repay the principal before the maturity rate

Coupon Rate

Coupon rate multiplied by the par value
2 to 10%
the interest rate used to compute the bond's interest payment each year
usually paid twice per year so divide by 2

Bond Price

80 to 120% of par value
the bond's price reported as a percentage of par value

TIPS (Treasury Inflation-Protected Securities

government bonds that value changes with inflation

mortgage-backed security

a security created when a group of mortgages are gathered together and bonds are sold to other institutions or the public

Bonds are sold in the

OTC market

The ask price is ____ than the bid

higher

Determine the interest payment for the following three bonds (Assume a $1,000 par value.)

3 ½ percent coupon corporate bond (paid semiannually): ½ × 0.035 × $1,000 = $17.50
4.25 percent coupon Treasury note: ½ × 0.0425 × $1,000 = $21.25
Corporate zero coupon bond maturing in ten years: 0.00 × $1,000 = $0

A 6 percent corporate coupon bond is callable in five years for a call premium of one year of coupon payments. Assuming a par value of $1,000, what is the price paid to the bondholder if the issuer calls the bond?

Principal + Call premium = $1,000 + 0.06 × $1,000 = $1,060.

Consider the following three bond quotes: a Treasury note quoted at 97.844, a corporate bond quoted at 103.25, and a municipal bond quoted at 101.90. If the Treasury and corporate bonds have a par value of $1,000 and the municipal bond has a par value of $5,000, what is the price of these three bonds in dollars?

Treasury note at 97.844% × $1,000 = 0.97844 × $1,000 = $978.44.
Corporate bond at 103.25: 103.25% × $1,000 = 1.0325 × $1,000 = $1,032.50.
Municipal bond at 101.90: 101.90% × $5,000 = 1.019 × $5,000 = $5,095.00.

Calculate the price of a zero coupon bond that matures in 20 years if the market interest rate is 3.8 percent. Assume semiannual compounding.

$471.01

What's the current yield of a 3.8 percent coupon corporate bond quoted at a price of 102.08?

Interest / Quote = Current Yield

= 3.8 / 102.08
= 3.72%

What's the taxable equivalent yield on a municipal bond with a yield to maturity of 3.5 percent for an investor in the 33 percent marginal tax bracket?

equivalent taxable yield = muni yield / (1 - tax rate)

= 3.5 / (1 - 0.33)
= 5.22%

Compute the price of a 3.8 percent coupon bond with 15 years left to maturity and a market interest rate of 6.8 percent. (Assume interest payments are semiannual.)

Is this a discount or premium bond?

Semiannual coupon = face value x rate/2
= $1,000 x (3.8% / 2)
= $19

Calculate present value of bond:
= $19 x (1 - (1 + 6.8 / 2))^-30 / (6.8%/2) +1,000 / (1 + 6.8%/2)^30
= $720.63

If face value > present value, bond issued at discount.
If face value < present value, bond is issued at premium.
If face value = present value, bond is issued at par value.

Therefore, the face value ($1,000) > present value ($720.63).

Therefore, the bond is issued at a discount.

Which of these is the key service provided by stock exchanges that attracts investors?

Liquidity

Which of these terms best describes the trading process used by NASDAQ?

Multiple market maker system

Which of these apply to publicly-issued common stock? Select all that apply.

Stock value depends on the issuer's business success

Value determined on the stock exchanges

Ownership position

What is the definition of market capitalization?

Current stock price times number of shares outstanding

How important is the liquidity provided by stock exchanges to the equity markets?

Very important

Which of these services should you expect to receive from a full-service brokerage firm?

-Investment advice
-In-depth research on individual stocks

brokers

located around the perimeter of the floor of the stock exchange, act as agents for those buying and selling stocks.

Which statements are correct? Select all that apply.

-A limit sell order will only execute at the limit price or higher.
-A market order will execute immediately, regardless of the price.
-A limit sell order may never be executed.

If you purchase shares of stock on NASDAQ, who is the most likely seller of those shares?

Dealer

True or false: The value of a firm as measured by its market capitalization is solely dependent upon the market value of the firm's stock.

False

Which one of these applies to stock valuation?

The value of a stock today equals the discounted value of the future expected cash flows.

Which one of the following characteristics most applies to a discount brokerage firm?

Investors place trades on the firm's Internet site

Which one of these best defines the dividend discount model?

A stock valuation method based on the present value of all future dividends

Which of these is correct?

Investors buy stocks at the bid price.

Dealers are willing to purchase stocks at the ask price.

Dealers are willing to sell stocks at the ask price.

Investors earn the spread.

Dealers are willing to sell stocks at the ask price.

Mary placed an order to purchase 100 shares of ABC stock at the going price. The order was filled as soon as it reached the floor of the exchange. What type of order did Mary purchase?

Market buy order

How is the discount rate used to value a stock related to the expected return on the stock? Assume the stock price fairly reflects the stock's value.

The discount rate should equal the expected rate of return.

Which one of these defines the current value of a stock?

Discounted value of both the future dividends and the future stock price

Which of these are basic assumptions of a variable growth rate valuation? Select all that apply.

g1 applies to a designated number of years
g2 < i
g1 can be negative positive or equal to zero

What is the key premise upon which the dividend discount model is based?

All future cash flows from a stock are dividend payments.

Which one of these generally applies to preferred stock?

Higher dividend yields than common stock issued by the same issuer

How is the discount rate used to evaluate a security related to the security's level of risk?

The higher the level of risk, the higher the discount rate needs to be.

A firm is expected to have net earnings of $4.00 per share of stock outstanding. The firm's current P/E ratio is 14 and it is expected to remain at that level. What is the firm's expected stock price for year 2?

$56.00
explanation: P2= P/E ratio x per-share earnings (14x4.00)

What is the best definition of the variable-growth rate stock valuation method?

Stock valuation method used when a firm's current growth rate is expected to change in the future

True or false: A P/E is a measure of relative value.

True

A firm is expected to have net earnings of $1,480,000 three years from now. There are 500,000 shares of stock outstanding. The firm's current P/E ratio is 18 and it is expected to remain at that level. What is the firm's expected stock price for year 3?

$53.28
Formula: P3 = 18 x (1,480,000 / 500,000)

True or false: A dealer will buy stock from an investor at the ask price.

False

What type of relationship exists between risk and expected return?

Positive

How is the term "dollar return" defined?

Amount of profit or loss from an investment expressed in dollars

How is the total dollar return on a stock investment calculated?

(Ending stock value - Beginning stock value) + Dividend income

The percentage total return on a stock investment is expressed as a percentage of what?

Initial Investment

Maria bought a stock one year ago for $16 a share. The stock pays quarterly dividends of $0.12 and is currently valued at $17 a share. How is the percentage return computed?

$17 - $16 + (4 × $0.12)]/$16

For the past three years, a stock had annual returns of 14 percent, -32 percent, and 4 percent. What is the average arithmetic return?

-4.67 percent

The dollar return on a stock investment includes which of these?

Dividend income and capital gains or losses

How can you best describe the relationship between the performance of long-term Treasury bonds and the S&P 500 during the period 2000-2012?

When one asset class incurred a loss, the other class had a positive rate of return

Theo purchased a stock at $28 a share and sold it six months later for $23 a share. He received a $0.75 dividend. How is his percentage return calculated?

($23 - $28 + $0.75)/$28

Which of these statements regarding the standard deviation formula is correct? Select all that apply.

(N - 1) is used when computing historical standard deviations.

The average return is an arithmetic average.

N is the total number of returns.

What is the shape of the efficient frontier and what does this imply?

Upward-sloping; direct relationship between risk and return

What determines the weights to be used in computing a portfolio rate of return? Select an answer that applies to both equal and unequal portfolio allocations.

Market value of each security expressed as a percentage of the total portfolio value

Common Stock

an ownership stake in a corporation
those who hold common stock are called Residual Claimants

new york stock exchange

the largest equities marketplace in the world and is home to more than 2,800 companies

NASDAQ Stock Market

is an electronic stock market without a physical trading floor
utilize market makers, or dealers

Stock Indexes

used to measure the performance of a particular group of stocks

Dow Jones Industrial Average

a price average of 30 large industry-leading firms

Standard & Poor's 500 Index

tracks 500 large companies
uses market capitalization, not just stock prices

NASDAQ Composite Index

a technology firm weighted index of stocks listed on the NASDAQ

bid price

the price at which a broker is willing to buy a certain security

ask price

the lowest price at which a broker will sell a stock

Market Order

order to be immediately executed at current market price

Limit Order

order at a specific price

Constant Growth Model

Stock Value= Next year's Dividend / (Discount rate - Growth Rate)

Preferred stock

a hybrid security that has characteristics of both long term debt and common stock

dollar return

the amount of profit or loss from an investment denoted in dollars
includes any capital gain or loss that occurred as well as any income you received over the period
- capital gain or loss + income
- (ending value- beginner value) + income

percentage return

the dollar return characterized as a percentage of money invested
used most often
- ending value - beginning value + income/beginning value x 100

average returns

summarize the past performance of an investment
- sum of all return/number of returns

Geometric mean return

computed by finding the equivalent return that is compounded for N periods

Standard Deviation

a measure of past return volatility, or risk, of an investment
square root of the variance
represents the total risk of a portfolio
large value indicates greater risk

coefficient of variation

amount of risk/return
standard deviation/average return
smaller CoV indicates better risk-reward relationship

portfolio

a combination of investment assets held by an investor

diversification

the process of putting money into different types of investments for the purpose of reducing the overall risk of the portfolio
minimum of 20 assets
50 or more to get peak benefits

firm-specific risk (diversifiable risk)

the portion of total risk that is attributable to firm or industry factors

Market risk (nondiversifiable risk)

the portion of total risk that is attributed to overall economic factors

Modern portfolio theory

shows the risk reduction occurs when securities are combined
describes how to combine stocks to achieve the highest expected return for the desired risk level

efficient portfolios

the set of portfolios that have the maximum expected return for each level of risk

correlation

the measurement of the co-movement between two variables that range between -1 and +1 with +1 meaning securities are in perfect sync