final exam

fin 3510

in-the-money

an option that would yield a positive payoff if exercised

out-of-the-money

an option that would not yield a positive payoff if exercised

at-the-money

stock price = strike price

delta

buying a fractional share of the underlying asset

american style

exercise anytime before expiration

european style

exercise only at expiration

prime rate

basic short-term interest rate for loans to creditworthy customers

federal funds rate

rate banks charge each other for overnight loans

discount

interest rate for loans from federal reserve to commercial banks

call money

interest rate for loans to brokerage firms

fisher hypothesis

suggests nominal rates reflect general inflation levels over time, staying above inflation rates

expectations theory

yield curve reflects market expectations on future rates

market segmentation theory

interest rates vary by market segment based on maturity

maturity preference theory

a maturity premium is necessary for longer-term loans due to increased risk

STRIPS

created by separating coupon and principal payments from treasury securities

TIPS

marketable treasury securities whose principal and interest payments are adjusted for inflation

premium bonds

coupon and current yield are higher than ytm

discount bonds

coupon rate and current yield are lower than ytm

par value bonds

coupon rate, current yield, and ytm are all equal.

interest rate risk

possibility that changes in interest rates will result in losses in the bonds value

reinvestment risk

uncertainty about the value of the portfolio on the target date

price risk

bonds in a dedicated portfolio will decrease in value in response to an increase in interest rates

dynamic immunization

periodic rebalancing of a dedicated bond portfolio for the purpose of maintaining a duration that matches target maturity date

diversification

holding multiple investments can mitigate risk as not all investments rise or fall simultaneously

beta

computed as weighted average. Beta of 1 is market average. Beta of 0 would be beta neutral.

correlation

tendency of the returns on two assets to move together. imperfect correlation helps reduce risk.

-1 perfect negative correlation

0 uncorrelated

+1 perfect positive correlation

futures contracts

standardized

forward contracts

customized

systematic risk

risk that influences a large number of assets

unsystematic risk

risk that influences a single company or small group of companies

correlation

tendency of the returns on two assets to move together

Malkiel’s Theorem 1

bond prices and bond yields move in opposite directions

Malkiel’s Theorem 2

the longer the term to maturity, the great the magnitude of change in bonds price.

Malkiel’s Theorem 3

for change in bonds ytm, the size of the change in bonds price increases at a diminishing rate as the bonds term to maturity lengthens

Malkiel’s Theorem 4

for change in bonds ytm, the resulting percentage change in the bonds price is inversely related to bonds coupon rate

Malkiel’s Theorem 5

for change in ytm, magnitude of the price increase caused by a decrease in the yield is greater than the price decrease caused by an increase in yield

reward-to-risk ratio

must be equal if they are correctly priced

capm

theory of risk and return for securities in a competitive capital market

security market line

underpriced - over SML

fairly priced - on the line

overpriced - under SML

efficient portfolio

offers highest return for its level of risk

minimum variance portfolio

lowest risk portfolio of any possible portfolio given the same securities but in differing proportions

spot-futures parity

futures price of a commodity is equal to future value of cash price calculated as risk-free rate.

futures inverted

futures is less than future spot price

future normal

futures is more than spot price

cross-hedging

refers to hedging particular short position with futures contracts on a related commodity or financial instrument.

long-hedge

investor buys a futures contract to protect against potential increases in the price of an asset they intend to buy in the future

short-hedge

selling a contract to deliver the asset at a predetermined price in the future to protect against decrease in price