Investments

Question 1

survival ratio and wealth ratio

Answer 1

survival ratio:
(salary income + asset income) / total expenses >1

wealth ratio:
asset income / total expenses > 1

Question 2

What are prerequisites for investing

Answer 2

already having cash savings and adequate insurance coverage

Question 3

what are common reasons why people invest?

Answer 3

1. income (retired people)
2. major expenditures (saving for college, house..)
3. retirement resources
4. shelter from taxes

Question 4

how do you determine the amount of investment capital?

Answer 4

it all depends on the expected average annual rate of return

Question 5

what is the capital market

Answer 5

a market facilitating the flow of surplus of funds from lenders/investors to those in deficit borrowers/issuers

Question 6

what are characteristics of the capital market?

Answer 6

securities maturity >1 year

Question 7

difference btwn primary and secondary capital markets

Answer 7

primary: financial securities newly issued

secondary: financial securities already issued

Question 8

what securities are there in a capital market?

Answer 8

equity: common stocks

debt: bonds

hybrid: preferred stocks, convertible preferred stocks, convertible bonds

Question 9

what are bonds?

Answer 9

bonds are long term debt instruments in which a borrower agrees to make payments of principal and interest on specific dates to a lender

Question 10

what is equity?

Answer 10

equity represents ownership of a firm, residual claim after all liabilities are paid

Question 11

who is the principal and who is the agent in corporation?

Answer 11

principal: shareholders

agent: management

Question 12

main difference between common and preferred stock:

Answer 12

dividends are fixed for preferred stock (still not guaranteed like in bonds), it also has higher seniority, no control, and lower liquidity

Question 13

what is the main difference between preferred stocks and bonds?

Answer 13

dividends of preferred stocks can be omitted without the fear of pushing the firm into bankruptcy. preferred stocks also offer higher returns

Question 14

what are convertible securities?

Answer 14

securities that allow for the conversion into common stock at pre-specified terms. they usually offer lower interest than non convertible counterparts

Question 15

what is the tradeoff every investor faces?

Answer 15

1. risk reward
2. high current income vs capital appreciation

Question 16

which formula explains best the risk return tradeoff?

Answer 16

return = risk free rate + risk premium

Question 17

which risks come with investing?

Answer 17

1. business risk: uncertainty regarding future cash flwos and the firms ability to meet operating expenses
2. financial risk:
   possibility that the firm will not sufficient cahs flows to meet debt obligations
3. market risk:
   results from swings in security prices
4. purchasing power: changes in the level of prices and inflation
5. interest rate:
   especially for bonds
6. liquidity:
   risk of not being able to liquidate

Question 18

which types of return are possible when investing?

Answer 18

1. current income
2. capital gains
3. interest on interest

Question 19

what makes for a good investment?

Answer 19

when approximate yield > desired rate of return

Question 20

approximate yield formula

Answer 20

(annual CI + [Pt - P0]/N) / [(P0 + Pt)/2]

Question 21

Difference between secured, subordinated, and guaranteed bonds

Answer 21

secured bonds are backed by collateral, guaranteed bonds are backed not only by the issuer but also by a third party, subordinated bonds are lower in priority

Question 22

which types of bond issuers are there?

Answer 22

governments, state enterprises, corporates

Question 23

rank claimants in order of repayment

Answer 23

1. senior bonds
2. normal bonds
3. subordinated bonds
4. preferred stocks
5. common stocks

Question 24

what is a trustee?

Answer 24

the bondholders’ representative appointed to oversee collateral backing a secured bonds

Question 25

what are callable bonds?

Answer 25

bonds that give the issuer the opportunity of early prepayment at pre specified terms (for example in case of credit rating upgrades or falling interest rates)

callable bonds have a higher discount rate, and a declining call premium

Question 26

What are putable bonds?

Answer 26

give the holder the right to be prepaid earlier and redeem the bonds, should the issuer not sustain some pre specified conditions

Question 27

which bond rating criteria do you know?

Answer 27

1. financial ratios (coverage, liquidity, profitability)
2. bond contract terms (secured or not, coventants..)
3. qualitative factors like earning stability, political factors

Question 28

what rating are junk bonds?

Answer 28

lower than BBB

Question 29

relationship between discount rate and coupon rate on bond valuation

Answer 29

r = c, sold at par
r < c, sold at premium
r > c, sold at discount

Question 30

how do you compute approximate yield to maturity?

Answer 30

YTM = current annual income + [(par - purchase price)/N] / [(purchase price + par value)/2]

Question 31

DDM

Answer 31

D1 / (r - g)

Question 32

what influences cost of equity?

Answer 32

market rates

market risk aversion

firm’s leverage

firm’s business risk