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CFA Level 2 > CFA Level 2 Flashcards - 3 > Flashcards

CFA Level 2 Flashcards - 3

1
Q

Relative valuation models

A

A model that specifies an asset’s value relative to the value of another asset.

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2
Q

Sell-side analysts

A

Analysts who work at brokerages.

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3
Q

Sum-of-the-parts valuation

A

A valuation that sums the estimated values of each of a company’s businesses as if each business were an independent going concern.

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4
Q

Valuation

A

The process of determining the value of an asset or service either on the basis of variables perceived to be related to future investment returns or on the basis of comparisons with closely similar assets.

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5
Q

Book value per share

A

The amount of book value (also called carrying value) of common equity per share of common stock, calculated by dividing the book value of shareholders’ equity by the number of shares of common stock outstanding.

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6
Q

Capitalization rate

A

The divisor in the expression for the value of perpetuity. In the context of real estate, it is the divisor in the direct capitalization method of estimating value. The cap rate equals net operating income divided by value.

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7
Q

Continuing value

A

The analyst’s estimate of a stock’s value at a particular point in the future.

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8
Q

Discount

A

To reduce the value of a future payment in allowance for how far away it is in time; to calculate the present value of some future amount. Also, the amount by which an instrument is priced below its face value.

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9
Q

Fixed-rate perpetual preferred stock

A

Nonconvertible, noncallable preferred stock that has a fixed dividend rate and no maturity date.

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10
Q

Forward dividend yield

A

A dividend yield based on the anticipated dividend during the next 12 months.

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11
Q

Free cash flow to equity

A

The cash flow available to a company’s common shareholders after all operating expenses, interest, and principal payments have been made and necessary investments in working and fixed capital have been made.

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12
Q

Free cash flow to the firm

A

The cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working and fixed capital have been made.

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13
Q

Gross domestic product

A

The market value of all final goods and services produced within the economy during a given period (output definition) or, equivalently, the aggregate income earned by all households, all companies, and the government within the economy during a given period (income definition).

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14
Q

Justified (fundamental) P/E

A

The price-to-earnings ratio that is fair, warranted, or justified on the basis of forecasted fundamentals.

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15
Q

Mature growth rate

A

The earnings growth rate in a company’s mature phase; an earnings growth rate that can be sustained long term.

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16
Q

No-growth company

A

A company without positive expected net present value projects.

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17
Q

No-growth value per share

A

The value per share of a no-growth company, equal to the expected level amount of earnings divided by the stock’s required rate of return.

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18
Q

Opportunity cost

A

Reflects the foregone opportunity of investing in a different asset. It is typically denoted by the risk-free rate of interest, r.

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19
Q

Perpetuity

A

A perpetual annuity, or a set of never-ending level sequential cash flows, with the first cash flow occurring one period from now.

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20
Q

Present value of growth opportunities

A

The difference between the actual value per share and the no-growth value per share. Also called value of growth.

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21
Q

Real options

A

Options that relate to investment decisions such as the option to time the start of a project, the option to adjust its scale, or the option to abandon a project that has begun.

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22
Q

Residual income

A

Earnings for a given period, minus a deduction for common shareholders’ opportunity cost in generating the earnings. Also called
economic profit or abnormal earnings.

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23
Q

Supernormal growth

A

Above-average or abnormally high growth rate in earnings per share.

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24
Q

Sustainable growth rate

A

The rate of dividend (and earnings) growth that can be sustained over time for a given level of return on equity, keeping the capital structure constant and without issuing additional common stock.

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25
Q

Terminal share price

A

The share price at a particular point in the future.

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26
Q

Terminal value of the stock

A

The analyst’s estimate of a stock’s value at a particular point in the future. Also called continuing value of the stock

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27
Q

Value of growth

A

The difference between the actual value per share and the no-growth value per share.

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28
Q

Visibility

A

The extent to which a company’s operations are predictable with substantial confidence.

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29
Q

Adjusted present value

A

As an approach to valuing a company, the sum of the value of the company, assuming no use of debt, and the net present value of any effects of debt on company value.

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30
Q

Accounting estimates

A

Estimates used in calculating the value of assets or liabilities and in the amount of revenue and expense to allocate to a period. Examples of accounting estimates include, among others, the useful lives of depreciable assets, the salvage value of depreciable assets, product returns, warranty costs, and the amount of uncollectible receivables.

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31
Q

American Depositary Receipt

A

A negotiable certificate issued by a depositary bank that represents ownership in a non-US company’s deposited equity (i.e., equity held in custody by the depositary bank in the company’s home market).

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32
Q

Basic earnings per share

A

(EPS) Net earnings available to common shareholders (i.e., net income minus preferred dividends) divided by the weighted average number of common shares outstanding during the period.

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33
Q

Benchmark value of the multiple

A

In using the method of comparables, the value of a price multiple for the comparison asset; when we have comparison assets (a group), the mean or median value of the multiple for the group of assets.

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34
Q

Bill-and-hold basis

A

Sales on a bill-and-hold basis involve selling products but not delivering those products until a later date.

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35
Q

Book value

A

The net amount shown for an asset or liability on the balance sheet; book value may also refer to the company’s excess of total assets over total liabilities. Also called carrying value.

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36
Q

Book value of equity

A

Shareholders’ equity (total assets minus total liabilities) minus the value of preferred stock; common shareholders’ equity.

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37
Q

Comparables

A

Assets used as benchmarks when applying the method of comparables to value an asset. Also called comps, guideline assets, or guideline companies.

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38
Q

Comps

A

Assets used as benchmarks when applying the method of comparables to value an asset.

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39
Q

Continuing earnings

A

Earnings excluding nonrecurring components. Also referred to as
core earnings, persistent earnings, or underlying earnings.

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40
Q

Core earnings

A

Earnings excluding nonrecurring components. Also referred to as continuing earnings, persistent earnings, or underlying earnings.

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41
Q

Cyclical businesses

A

Businesses with high sensitivity to business- or industry-cycle influences.

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42
Q

Diluted earnings per share

A

(Diluted EPS) Net income, minus preferred dividends, divided by the weighted average number of common shares outstanding considering all dilutive securities (e.g., convertible debt and options); the EPS that would result if all dilutive securities were converted into common shares.

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43
Q

Dilution

A

A reduction in proportional ownership interest as a result of the issuance of new shares.

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44
Q

Dividend displacement of earnings

A

The concept that dividends paid now displace earnings in all future periods.

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45
Q

Dividend rate

A

The annualized amount of the most recent dividend.

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46
Q

Earnings surprise

A

The portion of a company’s earnings that is unanticipated by investors and, according to the efficient market hypothesis, merits a price adjustment.

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47
Q

Earnings yield

A

EPS divided by price; the reciprocal of the P/E.

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48
Q

Economic sectors

A

Large industry groupings.

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49
Q

Enterprise value

A

Total company value (the market value of debt, common equity, and preferred equity) minus the value of cash and investments.

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50
Q

Enterprise value multiple

A

A valuation multiple that relates the total market value of all sources of a company’s capital (net of cash) to a measure of fundamental value for the entire company (such as a pre-interest earnings measure).

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51
Q

Forward P/E

A

A P/E calculated on the basis of a forecast of EPS; a stock’s current price divided by next year’s expected earnings.

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52
Q

Goodwill

A

An intangible asset that represents the excess of the purchase price of an acquired company over the value of the net identifiable assets acquired.

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53
Q

Guideline assets

A

Assets used as benchmarks when applying the method of comparables to value an asset.

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54
Q

Guideline companies

A

Assets used as benchmarks when applying the method of comparables to value an asset.

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55
Q

Harmonic mean

A

A type of weighted mean computed as the reciprocal of the arithmetic average of the reciprocals.

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56
Q

Human capital

A

An implied asset; the net present value of an investor’s future expected labor income weighted by the probability of surviving to each future age. Also called net employment capital.

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57
Q

Inverse price ratio

A

The reciprocal of a price multiple—for example, in the case of a P/E, the “earnings yield” E/P (where P is share price and E is earnings per share).

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58
Q

Justified price multiple

A

The estimated fair value of the price multiple, usually based on forecasted fundamentals or comparables.

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59
Q

Leading dividend yield

A

Forecasted dividends per share over the next year divided by current stock price.

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60
Q

Leading P/E

A

A P/E calculated on the basis of a forecast of EPS; a stock’s current price divided by next year’s expected earnings.

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61
Q

Market value of invested capital

A

The market value of debt and equity.

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62
Q

Method based on forecasted fundamentals

A

An approach to using price multiples that relates a price multiple to forecasts of fundamentals through a discounted cash flow model.

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63
Q

Method of comparables

A

An approach to valuation that involves using a price multiple to evaluate whether an asset is relatively fairly valued, relatively undervalued, or relatively overvalued when compared to a benchmark value of the multiple.

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64
Q

Minority interest

A

The proportion of the ownership of a subsidiary not held by the parent (controlling) company.

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65
Q

Molodovsky effect

A

The observation that P/Es tend to be high on depressed EPS at the bottom of a business cycle and tend to be low on unusually high EPS at the top of a business cycle.

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66
Q

Momentum indicators

A

Valuation indicators that relate either price or a fundamental (such as earnings) to the time series of their own past values (or in some cases to their expected value).

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67
Q

NTM P/E

A

Next 12-month P/E: current market price divided by an estimated next 12-month EPS.

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68
Q

Nonearning assets

A

Cash and investments (specifically cash, cash equivalents, and short-term investments).

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69
Q

Normal EPS

A

The EPS that a business could achieve currently under mid-cyclical conditions. Also called normalized EPS

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70
Q

Normalized EPS

A

The EPS that a business could achieve currently under mid-cyclical conditions. Also called normal EPS.

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71
Q

Normalized P/E

A

P/E based on normalized EPS data.

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72
Q

PEG ratio

A

The P/E-to-growth ratio, calculated as the stock’s P/E divided by the expected earnings growth rate.

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73
Q

Persistent earnings

A

Earnings excluding nonrecurring components. Also referred to as
core earnings, continuing earnings, or underlying earnings.

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74
Q

Price momentum

A

A valuation indicator based on past price movement.

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75
Q

Price multiples

A

The ratio of a stock’s market price to some measure of value per share.

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76
Q

Prospective P/E

A

A P/E calculated on the basis of a forecast of EPS; a stock’s current price divided by next year’s expected earnings.

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77
Q

Relative-strength indicators

A

Valuation indicators that compare a stock’s performance during a period either to its own past performance or to the performance of some group of stocks.

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78
Q

Return on invested capital

A

A measure of the profitability of a company relative to the amount of capital invested by the equity- and debtholders.

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79
Q

Scaled earnings surprise

A

Unexpected earnings divided by the standard deviation of analysts’ earnings forecasts.

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80
Q

Screening

A

The application of a set of criteria to reduce a set of potential investments to a smaller set having certain desired characteristics.

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81
Q

Shareholders’ equity

A

Total assets minus total liabilities.

82
Q

Standardized unexpected earnings

A

Unexpected earnings per share divided by the standard deviation of unexpected earnings per share over a specified prior time period.

83
Q

Tangible book value per share

A

Common shareholders’ equity minus intangible assets reported on the balance sheet, divided by the number of shares outstanding.

84
Q

Technical indicators

A

Momentum indicators based on price

85
Q

Terminal price multiples

A

The price multiple for a stock assumed to hold at a stated future time.

86
Q

Total invested capital

A

The sum of market value of common equity, book value of preferred equity, and face value of debt.

87
Q

Trailing dividend yield

A

The reciprocal of current market price divided by the most recent annualized dividend.

88
Q

Trailing P/E

A

A stock’s current market price divided by the most recent four quarters of EPS (or the most recent two semi-annual periods for companies that report interim data semi-annually). Also called current P/E.

89
Q

Underlying earnings

A

Earnings excluding nonrecurring components. Also referred to as
continuing earnings, core earnings, or persistent earnings.

90
Q

Unexpected earnings

A

The difference between reported EPS and expected EPS. Also referred to as an earnings surprise.

91
Q

Weighted harmonic mean

A

A type of weighted mean computed as the reciprocal of the arithmetic average of the reciprocals.

92
Q

Write-down

A

A reduction in the value of an asset as stated in the balance sheet.

93
Q

Abnormal earnings

A

Earnings for a given period, minus a deduction for common shareholders’ opportunity cost in generating the earnings. Also called
economic profit.

94
Q

Capital charge

A

The company’s total cost of capital in money terms.

95
Q

Clean surplus relation

A

The relationship between earnings, dividends, and book value in which ending book value is equal to the beginning book value plus earnings less dividends, apart from ownership transactions.

96
Q

Comprehensive income

A

All changes in equity other than contributions by, and distributions to, owners; income under clean surplus accounting; includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income equals net income plus other comprehensive income.

97
Q

Continuing residual income

A

Residual income after the forecast horizon.

98
Q

Discounted abnormal earnings model

A

A model of stock valuation that views intrinsic value of stock as the sum of book value per share plus the present value of the stock’s expected future residual income per share.

99
Q

Economic profit

A

Equal to accounting profit less the implicit opportunity costs not included in total accounting costs; the difference between total revenue (TR) and total cost (TC). Also called abnormal profit or supernormal profit.

100
Q

Economic value added

A

(EVA®) A commercial implementation of the residual income concept; the computation of EVA ® is the net operating profit after taxes minus the cost of capital, where these inputs are adjusted for a number of items.

101
Q

Edwards–Bell–Ohlson model

A

A model of stock valuation that views intrinsic value of stock as the sum of book value per share plus the present value of the stock’s expected future residual income per share.

102
Q

Equity charge

A

The estimated cost of equity capital in money terms.

103
Q

Impairment

A

Diminishment in value as a result of carrying (book) value exceeding fair value and/or recoverable value.

104
Q

Other comprehensive income

A

Items of comprehensive income that are not reported on the income statement; comprehensive income minus net income.

105
Q

Residual income model

A

(RIM) A model of stock valuation that views intrinsic value of stock as the sum of book value per share plus the present value of the stock’s expected future residual income per share. Also called discounted abnormal earnings model or Edwards–Bell–Ohlson model.

106
Q

Tobin’s q

A

The ratio of the market value of debt and equity to the replacement cost of total assets.

107
Q

Agency issues

A

Conflicts of interest that arise when the agent in an agency relationship has goals and incentives that differ from the principal to whom the agent owes a fiduciary duty. Also called agency problems or principal–agent problems.

108
Q

Asset-based approach

A

Approach that values a private company based on the values of the underlying assets of the entity less the value of any related liabilities.

109
Q

Capitalization of earnings method

A

In the context of private company valuation, a valuation model based on an assumption of a constant growth rate of free cash flow to the firm or a constant growth rate of free cash flow to equity.

110
Q

Capitalized cash flow method

A

In the context of private company valuation, a valuation model based on an assumption of a constant growth rate of free cash flow to the firm or a constant growth rate of free cash flow to equity. Also called capitalized cash flow model.

111
Q

Capitalized income method

A

In the context of private company valuation, a valuation model based on an assumption of a constant growth rate of free cash flow to the firm or a constant growth rate of free cash flow to equity

112
Q

Cash-generating unit

A

The smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows of other assets or groups of assets.

113
Q

Compiled financial statements

A

Financial statements that are not accompanied by an auditor’s opinion letter.

114
Q

Contingent consideration

A

Potential future payments to the seller that are contingent on the achievement of certain agreed-on occurrences.

115
Q

Cost approach

A

An approach that values a private company based on the values of the underlying assets of the entity less the value of any related liabilities. In the context of real estate, this approach estimates the value of a property based on what it would cost to buy the land and construct a new property on the site that has the same utility or functionality as the property being appraised.

116
Q

Discount for lack of control

A

An amount or percentage deducted from the pro rata share of 100% of the value of an equity interest in a business to reflect the absence of some or all of the powers of control.

117
Q

Discount for lack of marketability

A

An amount of percentage deducted from the value of an ownership interest to reflect the relative absence of marketability

118
Q

Discounted cash flow method

A

Income approach that values an asset based on estimates of future cash flows discounted to present value by using a discount rate reflective of the risks associated with the cash flows. In the context of real estate, this method estimates the value of an income-producing property based on discounting future projected cash flows.

119
Q

Excess earnings method

A

Income approach that estimates the value of all intangible assets of the business by capitalizing future earnings in excess of the estimated return requirements associated with working capital and fixed assets.

120
Q

Expanded CAPM

A

An adaptation of the CAPM that adds to the CAPM a premium for small size and company-specific risk.

121
Q

Financial transaction

A

A purchase involving a buyer having essentially no material synergies with the target (e.g., the purchase of a private company by a company in an unrelated industry or by a private equity firm would typically be a financial transaction).

122
Q

Free cash flow method

A

Income approach that values an asset based on estimates of future cash flows discounted to present value by using a discount rate reflective of the risks associated with the cash flows

123
Q

Guideline public companies

A

Public-company comparables for the company being valued.

124
Q

Guideline public company method

A

A variation of the market approach; establishes a value estimate based on the observed multiples from trading activity in the shares of public companies viewed as reasonably comparable to the subject private company.

125
Q

Guideline transactions method

A

A variation of the market approach; establishes a value estimate based on pricing multiples derived from the acquisition of control of entire public or private companies that were acquired.

126
Q

Income approach

A

A valuation approach that values an asset as the present discounted value of the income expected from it. In the context of real estate, this approach estimates the value of a property based on an expected rate of return. The estimated value is the present value of the expected future income from the property, including proceeds from resale at the end of a typical investment holding period.

127
Q

Market approach

A

Valuation approach that values an asset based on pricing multiples from sales of assets viewed as similar to the subject asset.

128
Q

Normalized earnings

A

The expected level of mid-cycle earnings for a company in the absence of any unusual or temporary factors that affect profitability (either positively or negatively)

129
Q

Premise of value

A

The status of a company in the sense of whether it is assumed to be a going concern or not.

130
Q

Prior transaction method

A

A variation of the market approach; considers actual transactions in the stock of the subject private company.

131
Q

Reporting unit

A

For financial reporting under US GAAP, an operating segment or one level below an operating segment (referred to as a component).

132
Q

Residual income method

A

Income approach that estimates the value of all intangible assets of the business by capitalizing future earnings in excess of the estimated return requirements associated with working capital and fixed assets.

133
Q

Reviewed financial statements

A

A type of non-audited financial statements; typically provide an opinion letter with representations and assurances by the reviewing accountant that are less than those in audited financial statements.

134
Q

Strategic transaction

A

A purchase involving a buyer that would benefit from certain synergies associated with owning the target firm.

135
Q

Venture capital investors

A

Private equity investors in development-stage companies.

136
Q

Barbell portfolio

A

Fixed-income portfolio that combines short and long maturities.

137
Q

Bearish flattening

A

Term structure shift in which short-term bond yields rise more than long-term bond yields, resulting in a flatter yield curve.

138
Q

Bond risk premium

A

The expected excess return of a default-free long-term bond less that of an equivalent short-term bond.

139
Q

Bullet portfolio

A

A fixed-income portfolio concentrated in a single maturity.

140
Q

Bullish flattening

A

Term structure change in which the yield curve flattens in response to a greater decline in long-term rates than short-term rates.

141
Q

Bullish steepening

A

Term structure change in which short-term rates fall by more than long-term yields, resulting in a steeper term structure

142
Q

Curvature

A

One of the three factors (the other two are level and steepness) that empirically explain most of the changes in the shape of the yield curve. A shock to the curvature factor affects mid-maturity interest rates, resulting in the term structure becoming either more or less hump-shaped.

143
Q

Discount factor

A

The price equivalent of a zero rate. Also may be stated as the present value of a currency unit on a future date.

144
Q

Discount function

A

Discount factors for the range of all possible maturities. The spot curve can be derived from the discount function and vice versa.

145
Q

Flight to quality

A

During times of market stress, investors sell higher-risk asset classes such as stocks and commodities in favor of default-risk-free government bonds.

146
Q

Forward curve

A

A series of forward rates, each having the same time frame.

147
Q

Forward pricing model

A

The model that describes the valuation of forward contracts.

148
Q

Forward rate

A

An interest rate determined today for a loan that will be initiated in a future period.

149
Q

Forward rate model

A

The forward pricing model expressed in terms of spot and forward interest rates.

150
Q

I-spreads

A

Shortened form of “interpolated spreads” and a reference to a linearly interpolated yield.

151
Q

Level

A

One of the three factors (the other two are steepness and curvature) that empirically explain most yield curve shape changes. A shock to the level factor changes the yield for all maturities by an almost identical amount.

152
Q

Libor–OIS spread

A

The difference between Libor and the overnight indexed swap rate.

153
Q

Liquidity preference theory

A

A term structure theory that asserts liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term.

154
Q

Liquidity premium

A

An extra return that compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly.

155
Q

Local expectations theory

A

A term structure theory that contends the return for all bonds over short periods is the risk-free rate.

156
Q

Overnight indexed swap (OIS) rate

A

An interest rate swap in which the periodic floating rate of the swap equals the geometric average of a daily unsecured overnight rate (or overnight index rate).

157
Q

Par curve

A

A sequence of yields-to-maturity such that each bond is priced at par value. The bonds are assumed to have the same currency, credit risk, liquidity, tax status, and annual yields stated for the same periodicity.

158
Q

Par swap

A

A swap in which the fixed rate is set so that no money is exchanged at contract initiation.

159
Q

Preferred habitat theory

A

A term structure theory that contends that investors have maturity preferences and require yield incentives before they will buy bonds outside of their preferred maturities.

160
Q

Pure expectations theory

A

A term structure theory that contends the forward rate is an unbiased predictor of the future spot rate. Also called the unbiased expectations theory.

161
Q

Rolling down the yield curve

A

A maturity trading strategy that involves buying bonds with a maturity longer than the intended investment horizon. Also called riding the yield curve.

162
Q

Secured overnight financing rate (SOFR)

A

A daily volume-weighted index of rates on qualified cash borrowings collateralized by US Treasuries that is expected to replace Libor as a floating reference rate for swaps

163
Q

Segmented markets theory

A

A term structure theory that contends yields are solely a function of the supply and demand for funds of a particular maturity.

164
Q

Shaping risk

A

The sensitivity of a bond’s price to the changing shape of the yield curve.

165
Q

Spot curve

A

A sequence of yields-to-maturity on zero-coupon bonds. Sometimes called zero or strip curve (because coupon payments are “stripped” off the bonds).

166
Q

Spot rate

A

The interest rate that is determined today for a risk-free, single-unit payment at a specified future date.

167
Q

Spot yield curve

A

The term structure of spot rates for loans made today.

168
Q

Steepness

A

The difference between long-term and short-term yields that constitutes one of the three factors (the other two are level and curvature) that empirically explain most of the changes in the shape of the yield curve.

169
Q

Swap curve

A

The term structure of swap rates.

170
Q

Swap rate curve

A

The term structure of swap rates.

171
Q

Swap spread

A

The difference between the fixed rate on an interest rate swap and the rate on a Treasury note with equivalent maturity; it reflects the general level of credit risk in the market.

172
Q

TED spread

A

A measure of perceived credit risk determined as the difference between Libor and the T-bill yield of matching maturity

173
Q

Term premium

A

The additional return required by lenders to invest in a bond to maturity net of the expected return from continually reinvesting at the short-term rate over that same time horizon.

174
Q

Unbiased expectations theory

A

A term structure theory that contends the forward rate is an unbiased predictor of the future spot rate. Also called the pure expectations theory.

175
Q

Yield curve factor model

A

A model or a description of yield curve movements that can be considered realistic when compared with historical data.

176
Q

Zero

A

A bond that does not pay a coupon but is priced at a discount and pays its full face value at maturity.

177
Q

Zero-coupon bond

A

A bond that does not pay interest during its life. It is issued at a discount to par value and redeemed at par. Also called pure discount bond

178
Q

Arbitrage-free models

A

Term structure models that project future interest rate paths that emanate from the existing term structure. Resulting prices are based on a no-arbitrage condition.

179
Q

Arbitrage-free valuation

A

An approach to valuation that determines security values consistent with the absence of any opportunity to earn riskless profits without any net investment of money.

180
Q

Arbitrage opportunity

A

An opportunity to conduct an arbitrage; an opportunity to earn an expected positive net profit without risk and with no net investment of money.

181
Q

Cox-Ingersoll-Ross model

A

A general equilibrium term structure model that assumes interest rates are mean reverting and interest rate volatility is directly related to the level of interest rates.

182
Q

Dominance

A

An arbitrage opportunity when a financial asset with a risk-free payoff in the future must have a positive price today.

183
Q

Ho–Lee model

A

The first arbitrage-free term structure model. The model is calibrated to market data and uses a binomial lattice approach to generate a distribution of possible future interest rates.

184
Q

Kalotay–Williams–Fabozzi (KWF) model

A

An arbitrage-free term structure model that describes the dynamics of the log of the short rate and assumes constant drift, no mean reversion, and constant volatility.

185
Q

Law of one price

A

A principle that states that if two investments have the same or equivalent future cash flows regardless of what will happen in the future, then these two investments should have the same current price

186
Q

Principle of no arbitrage

A

In well-functioning markets, prices will adjust until there are no arbitrage opportunities.

187
Q

Reconstitution

A

When dealers recombine appropriate individual zero-coupon securities and reproduce an underlying coupon Treasury.

188
Q

Stripping

A

A dealer’s ability to separate a bond’s individual cash flows and trade them as zero-coupon securities.

189
Q

Value additivity

A

An arbitrage opportunity when the value of the whole equals the sum of the values of the parts.

190
Q

Vasicek model

A

A partial equilibrium term structure model that assumes interest rates are mean reverting and interest rate volatility is constant.

191
Q

Callable bond

A

A bond containing an embedded call option that gives the issuer the right to buy the bond back from the investor at specified prices on pre-determined dates.

192
Q

Capped floater

A

Floating-rate bond with a cap provision that prevents the coupon rate from increasing above a specified maximum rate. It protects the issuer against rising interest rates.

193
Q

Conversion period

A

For a convertible bond, the period during which bondholders have the right to convert their bonds into shares.

194
Q

Conversion price

A

For a convertible bond, the price per share at which the bond can be converted into shares.

195
Q

Conversion rate (or ratio)

A

For a convertible bond, the number of shares of common stock that a bondholder receives from converting the bond into shares.

196
Q

Conversion value

A

For a convertible bond, the value of the bond if it is converted at the market price of the shares. Also called parity value

197
Q

Convertible bond

A

Bond that gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company.

198
Q

Effective convexity

A

A curve convexity statistic that measures the secondary effect of a change in a benchmark yield curve on a bond’s price.

199
Q

Effective duration

A

Sensitivity of the bond’s price to a 100 bps parallel shift of the benchmark yield curve, assuming no change in the bond’s credit spread.

200
Q

Embedded options

A

Contingency provisions found in a bond’s indenture or offering circular representing rights that enable their holders to take advantage of interest rate movements. They can be exercised by the issuer, by the bondholder, or automatically depending on the course of interest rates.

CFA Level 2 (5 decks)

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