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Financial Economics > E1 P2- Lectures 2-4 > Flashcards

E1 P2- Lectures 2-4 Flashcards

1
Q

What is the foundation of any investment transaction?

A

sacrifice of present cash flow for a future cash flow

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2
Q

When an investment is made compenstion must be made because of 3 things. What are they ?

A
  1. Level of impatience - waiting for your cash
  2. Risk - uncertainty of income
  3. Inflation - purchasing power of money may drop
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3
Q

What does a dollar today > a dollar tomorrow mean?

A

Money has a time-value, having it today is more valuable as you could invest it and earn an interest.

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4
Q

What does interest rate tell you?

A

How high the rewards are / how costly borrowing is

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5
Q

What is FV?

A

Future Value - it is the amount an investment will grow at the end of a period after gaining interest

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6
Q

What is PV?

A

Present Value - the value today of a future cashflow

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7
Q

What is discount rate?

A

The interest rate used to discount cash flows received in future years. It is the opportunity cost of capital, given the risk of future cash flows.

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8
Q

Exam tip: what is helpful when working out PV and using discount rates?

A

Put on timeline

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9
Q

The longer you have to wait for your money the less it is worth today. What does this mean for discount rates and present value?

A

The higher the discount rate, the lower the PV

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10
Q

What is a perpetuity?

A

A constant stream of identical cash flows that lasts forever.

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11
Q

Give 3 examples of perpetuities

A
  1. Real estate
  2. Consols (perpetual bonds)
  3. Shares (Gordon growth model)
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12
Q

What is the difference between an annuity and a perpetuity?

A

A perpetuity has no termination date

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13
Q

What is a growing perpetuity?

A

A stream of cash flows that grow at a constant rate forever?

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14
Q

What is an annuity?

A

A stream of constant cash flows that last for a fixed number of periods

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15
Q

When is an annuity ordinary?

A

When cash flows occur at the end of each period

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16
Q

Give 3 examples of an ordinary annuity

A

Equities, bonds, regular loans

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17
Q

What is it called when an cash flows occur at the beginning of a period?

A

It is an Annuity due

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18
Q

Give 3 examples of annuities due. Why is this the case?

A

rent, phone bills, insurance coverage

remember it is like paying for a service, you must pay first to use

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19
Q

Whenever you are working out the PV of a perpetuity, what must you do on a timeline?

A

Discount it until you are back to year 0

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20
Q

How do you do derive annuities from perpetuities?

A

It is the difference between an annuity starting from year 1 and one from year 1 + t

equation wise it is the expanded PV of an annuity one - c/r (1 - 1/(1+r)

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21
Q

Define a coupon and coupon rate

A

Coupon - periodic interest paid on a bond
Coupon rate - the interest rate expressed as a % of the face value and paid until maturity

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22
Q

What market do bonds operate in?

A

Bought and sold in the secondary market

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23
Q

What is the face/par/principle value of a bond?

A

Is the principal payment at the maturity of a bond

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24
Q

Define a bond

A

Debt security that gives the owner an enforceable right to certain future payments (coupon payments).

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25
Q

Name the 6 types of bonds.

A
  1. Plain vanilla / single-dated / straight
  2. Zeros
  3. Strips
  4. Index-linked
  5. Consol / undated / perpetual
  6. Floaters / floating rate
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26
Q

What is a Plain vanilla / single-dated / straight bond?

A

exact amounts and timing of all payments are set at the time of issue

27
Q

What are zero-coupon / Zeros bonds?

A

investors achieve their whole return at maturity with no interest payments. Their profit is their interest

self-explanatory

28
Q

What are Consol / undated / perpetual bonds?

A

issuer has the right (but not obligation) to repay the bond at any time but may continue to pay C (in perpetuity) forever instead

29
Q

What are strips?

A

the separate sale of coupon payments stripped from a C bond

30
Q

What are index-linked bonds?

A

Bonds that adjust their interest rate and V in line with inflation

31
Q

What are floaters?

A

bonds where the coupon rate is not fixed but is reset periodically

32
Q

What do you call sterling-denominated UK gov bonds?

A

gilts

33
Q

How are gilts divided?

A

by “maturity to redemption” into long, medium, short, ultra-short and undated

34
Q

Who issues bonds?

A

Central gov, local gov and municipalities as well as companies and supranational institutions

35
Q

What is a benefit of the Debt management office (DMO) publishing all info?

A

Transparency can help reduce interest the treasury is charged for borrowing money

36
Q

Describe the allocation of bonds in the UK market?

A

First bonds are given out via competitive public auctions (primary market) to the GEMMs (gilt-edged market makers)
Then, bonds are traded on secondary markets

37
Q

Describe conventional gilts.

A

Single-dated bonds that pay interest semi-annually

38
Q

If an index-linked gilt is named 1.5% Treasury Gilt ‘24, what is the coupon rate and what is the year of maturity ?

A

1.5% c and 2024

39
Q

How do insurance companies with long-term liabilities effectively purchase and sell gilts?

A

They buy gilts with the same maturity as their commitments so they are certain they can pay them off

40
Q

Why do banks and building societies purchase gilts?

A

They keep investment in gilts because they are considered liquid assets.

41
Q

Why are gilts considered liquid?

A

They are actively traded in financial markets and their underlying assets are usually cashflows of the government which are trusted

- therefore they are also less risky

42
Q

Long-term bonds are more affected by interest rates than short-term bonds. When do two bonds that are the same but different lengths sell for the same face value?

A

When c = r

43
Q

what are the two measures of debt securities?

A

interest yield and redemption yield

44
Q

Describe interest yield as a measurement of bonds

4 things

A

It divides Coupon by clean price
does not consider time value of money
ignores capital loss/ gains
ignores accrued interest

45
Q

What is the redemption yield (APR) also known as?

A

Yield to maturity (YTM) and internal rate of return (IRR)

46
Q

Describe redemption yield (APR) as a measurement of bonds

3 things

A
  • considers the time value of money
  • assumes the bond is acquired on the coupon date and is held until maturity
  • for bond with more than 1 year until maturity it is calculated using trial and error
47
Q

Describe premium bonds

A

A bond with a current price > par value. Ie it trades for above £100

as par value is £100

48
Q

Describe discount bonds

A

A bond with a current price < par value. ie trades for below £100

49
Q

What happens if you hold a discount bond until redemption?

A

capital gains

50
Q

What happens if you hold a premium bond until redemption?

A

It converges to V making you susceptible to capital losses

51
Q

What does it mean for a bond if the coupon rate is = to the discount rate?

A

price = £100

52
Q

What is the difference between coupons and dividends?

3 things

A

Bonds vs Stocks
Usually fixed vs variable on company performance
Obligated vs usually not (can reinvest in to company)

53
Q

Like bonds stocks have 2 cash flows, what are they?

A

Dividends and sell price when stock is sold

sell price dependent on future dividends

54
Q

What model do you use when a stock has no dividend growth?

A

zero growth model

55
Q

What does the Dividend discount model predict?

A
  • the value of an ordinary share equals the PV of all expected future payments
56
Q

What does the return on a stock equation split into?

A

Dividend yield (%) D1 / P0*100
or

Capital gain yield (%) (P1 - P0) / P0*100

second can be positive (Capital gain) and negative (loss). it is also =

57
Q

Do dividends reflect profitability?

A

No, they reflect a company’s dividend policy, NOT its profitability

58
Q

What are the limitations of Gordon’s growth model?

4 things

A
  • some companies may have no D history
  • relies on the assumption the ‘normal’ growth rate, g is known and stable
  • small changes in g and r greatly change P0
  • does not consider nondividend company value like customer retention and brand loyalty
59
Q

What is the solution to the limitations of the GGM?

A

Earnings Per Share (EPS) - look at earnings rather than dividends

60
Q

What is EPS made of?

A

a company’s profit divided by the outstanding shares of its common stock.

61
Q

Why might stock price rise after a company temporarily reduces D?

A
  • may be reinvested into the company, promising higher future D
62
Q

Define spot rates

A
  • rates / prices quoted for an investment right now (on the spot)
  • they determine the price of a bond
63
Q

Define forward interest rate

A

an interest rate applicable to an investment that will take place in the future

Financial Economics (11 decks)

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