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Flashcards in Exam 2 Deck (113):
1

Interest rate levels

Price of capital. Borrows are willing to pay and lenders are going to recieve

2

What are the four factors that affect interest rates?

Production opportunities, time preferences for consumption, risk, and expected inflation

3

Time preferences for consumption

Supply side. More in future high supply =lower interest rate

4

Risk

Higher risk=higher interest

5

Expected inflation

High inflation = high IR

6

R*

Real risk free rate of interest

7

Rrf

The nominal rate of interest on treasury securities

8

Rrf=

R*+IP

9

Interest rate equation

R*+IP+DRP+LP+MRP

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R

Required return on a debt security

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DRP

Default risk premium. Chance for borrower not to make payment

12

LP

Liquidity premium. Convertibility to cash at fair market value

13

MRP

Maturity risk premium. Price of long term bonds changes over time as interest rate changes. Risk of capital loss

14

Short term treasury

IP

15

Long term treasury

IP and MRP

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Short term corporate

IP DRP LP

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Long term corporate

IP MRP DRP LP

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Term structure

Relationship between interest rates and maturities

19

Yeild curve step one

Find the average expected inflatiob rate over years

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Yeild curve step two

Find the appropriate maturity risk premium. .1%(t-1)

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Yeild curve step 3

Add the premiums to r*

22

Upward sloping yeild curve

Due to an increase in expected inflation and MRP

23

Corporate yeild curves

Are higher than that of treasury securities though not parallel to t-curve

24

The spread between corporate and treasury yeild curves

Widens as fhe corporate bond rating decreases

25

Since corporate yields include a DRP and LP the yield spread can be calculated as

Corporate bond yield-Treasury bond yield
DRP+LP

26

Investment grade bonds

BBB and higher. Investment companies can only invest in these

27

Junk bond

BB and lower

28

Pure expectations theory

Contends that the shape of the yield curve depends on investors expectations about future interest rates. IR increase LT rates will be higher than ST rates

29

Assumptions of pure expectations

MRP for T-securities is zero, LT rates are an average of current and future ST rates, use to guess future rates

30

Macro factors that influence IR

Federal reserve policy, federal budget deflicits or surpluses, international factors, level of business activity

31

Federal reserve policy

Short term: money increases IR decreases
Long term: inflation increases IR increases

32

Bonds are primarily traded in the

Over the counter market

33

Most bonds are owned by and teades among

Large financial institutions

34

Par value

Face amount paid at maturity

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Coupon rate

Stated interest rate

36

Yield to maturity

Rate of return earned on a bond held until maturity

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Call provision

Allows issuer to refund the bond if rates decline, bond premium, deferred call and declining call

38

Sinking fund

Provision to pay off a loan over its life rather than all at maturity. Reduces risk to investor. Investors have reinvestment risk

39

Convertable bond

May be exchanged for common stock of the firm at the holders option

40

Warrant

Long term option to buy a stated number of shares of common stock at a specific price

41

Putable bond

Allows holder to sell the bond back to the company prior to maturity

42

Income bond

Pays interest only when interest is earned by the firm

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Indexed bond

Interest paid is based upon the rate of inflation CPI+%

44

Opportunity cost of debt capital

Discount rate. Rate that could be earned on alternative investments of equal risk

45

If Rd remains constant

The value of prmium bond will decrease, value of discount bond will increase, par value stays the same

46

Current yield

Annual coupon payment/ current price

47

Capital gains yield

Change in price/ begining price

48

Expected total return

YTM= expected CY+ expected CGY

49

The longer the bond

The higher the price risn

50

Reinvestment risk

The concern that the rd will fall and the future CFs will have to be reinvested at lower rates

51

Short term/high coupon bonds

Low price risk, high reinvestment risk

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Long term/ low coupon

High price risk, low reinvestment risk

53

Semiannual bonds

Period: 2N
Periodic rate: rd/2
PMT= annual rate/2

54

Callable bonds YTM or YTC

If YTC

55

When is a call more likely to occur?

Market

56

Default risk

Influenced by the issuers finanacal strength and the terms of the bond contract

57

Mortgage bonds

Backed by fixed assets

58

Debenture bonds

Bond with no collateral

59

Subordinated debenture

3rd tear

60

Liquidation

Assets are auctioned off to obtain cash that is then distrubuted to creditors

61

Priority claims of liquidation

Secured creditors, trustee costs, wages, taxes, unfunded pensions, unsecured creditors, preferred stock, common stock

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Reprganization

Emerges from bankruptcy with lower debts reduced interest and a chance for success. Unsecured creditors more willing to participate

63

Investment risk

The chance that unfavorable events will occur from an investment. Probability that earn low or negative return

64

Stand alone risk

Investing in one companys stock

65

Portfolio risk

Investing in multiple companys stock

66

Probability distributions

Narrower is lower risk. Wider is higher risk

67

Stocks are said to provide

Relativly higher return with higher risk. Trade off

68

High tech relative to economy

Moves with the economy and has positive correlation

69

Collections relation to economy

Is countercyclical and has negative correlation

70

Expected rate of return calculation

Weighted average of all probablities

71

Standard deviation for each investment

Weighted average of expected returns minus actual returns

72

Larger SD

The lower the prob that actual returns will be closer to expected returns. Associated with a wider prob distribution of returns

73

Corfficient of variation

A standardized measure of dispersion about the expected value that shows the risk per unit of return. SD/expected return

74

Risk aversion

Assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities

75

Risk premium

The difference between the return on a risky asset and riskless asset which serves as compensation for investors to hold riskier securites

76

A portfolios expected return is

A weighted average of the returns of the portfolios component assets

77

Correlation

A tendency of 2 variables to move together

78

SD for average stock

35%

79

Most stocks are

Positivley correlated with the market

80

Correlation that is very low or negative

Reduces risk

81

Stand alone risk =

Market risk + diversifiable risk

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Market risk

Portion of a securitys stand alone risk that cannot be eliminated through diversification. Measured by beta

83

Diversifiable risk

Portion of a securitys stand alone risk that can be eliminated through proper disverification

84

Capital asset pricing model

Model linking risk and required returns

85

CAPM suggests

That there is a security market line that states a stocks required return equals the risk free return plus a risk premium

86

Primary conclustion for CAPM

The relevant riskiness of a stock is its contributiob to the riskibess of a well diversified portfolio. Not to the riskiness of added specific asset

87

Beta

Measures a stocks market risk and shows voliatiliy relatice to the market. Indicates how risky a stock is if held in difersified

88

Beta equation

Ri/rm

89

Beta=1

The security is just as risky as the average stock

90

Beta>1

Riskier than average

91

Beta<1

Less risky than average

92

SML equation

Ri= Rrf+ (Rm-Rrf) b

93

Market risk premium

Additional return over risk free needed to compensate investors for assuming an average amount of risk (Rm-Rrf)

94

Fed stimilates

R* decreases causing a decrease in Rrf and SMl decreases

95

Facts about common stock

Represent ownership, implies control, elect directors, directs elect management, management max stock price

96

Stocks with price below intrinsic value

Undervalued

97

Discounted dividend model

Value of a stock is the present value of the future dividends expected to be generated

98

Stock price equation DDM

D1/rs-g

99

Growth factor is

Comes feom the RE and reinvestment. The increased % of RE means increased g

100

Dividend yield

D1/Po (dividends/stock price)

101

Capital gains yield stock

P1-po/po
%change in stock price

102

Total return stock

Dividend yield-capital gains yield

103

If g=0

Would be perpetuity. Pmt/r

104

Negitive growth stock

Do(1+g)/(rs-g)

105

Corporate valuation model

Free cash flow method. Suggest the value of the entire firm equals the present value of the firms free cash flows

106

Free cash flows equation

(Ebit(1-T)+dep)-(capital expenditures+change in working captial)

107

Applying CVM

1) find pv of FCF
2) subtract debt anf preferred stock
3) divide by # of shares

108

Issues CVM

Used when firm doesnt pay dividends, assumes fcf growth constant, horizon value is point growth becomes constant

109

Firm multiples method

Analysts often us the following multiples to value stocks:p/e, p/cf, p/sales. Multiply but expected earnings

110

Economic value added approach

Find EVA, add future values to BV of equity, divide by # of shares

111

EVA

Equaity capital(ROE-cost of equity)

112

Preferred stock

Hybrid security, fixed dividends that must be paid before common stock, dont have to pay

113

Preferred stock expected return

Dividends/selling price