Exam 3 (Chap 6, 7, 10, 11) Flashcards
(31 cards)
- How is bond market different from stock market? Please list out at least three differences.
Ownership vs. Lending: Stocks represent ownership in a company; bonds represent a loan to the company or government.
Returns: Stock returns come from dividends and price appreciation; bond returns come from fixed interest (coupon) payments.
Risk/Volatility: Stocks are generally more volatile; bonds are more stable but can still carry credit and interest rate risk.
- What is face value/par value/coupon rate/coupon payment/maturity date/yield to maturity of
a bond?
Face/Par Value: The amount the bondholder receives at maturity (usually $1,000).
Coupon Rate: The fixed annual interest rate based on the bond’s face value.
Coupon Payment: The periodic interest payment (e.g., 5% of $1,000 = $50/year).
Maturity Date: When the bond expires, and the principal is repaid.
Yield to Maturity (YTM): The total return expected if the bond is held to maturity, considering both coupon payments and capital gain/loss.
- How do we find the value of a bond? How is this approach similar to the approach we use to
find the value of a company or the price of a stock?
Bond Value = Present value of future coupon payments + Present value of face value at maturity.
Similarity to Stock Valuation: Like discounted cash flow (DCF) for stocks, bond valuation discounts future cash flows to present value using a required rate of return.
- In our class discussion, we have talked about that there is an inverse relationship between the
YTM and the price of a bond. Please explain briefly why this is the case?
As YTM increases, bond price falls, because existing bonds with lower coupon rates become less attractive compared to new bonds offering higher returns, and vice versa.
- Please briefly explain the difference between the coupon rate and the required return on a
Bond.
Coupon Rate: Fixed interest rate paid on the bond.
Required Return (YTM): Market-determined rate based on risk and interest rates.
If the required return differs from the coupon rate, the bond’s price will differ from its par value.
- What is a par/discount/premium bond? Under what circumstance will a bond be traded at
par/discount/premium and why?
Par Bond: Price = Face value; occurs when coupon rate = required return.
Discount Bond: Price < Face value; coupon rate < required return.
Premium Bond: Price > Face value; coupon rate > required return.
- Explain how changes in interest rates impact the price of existing bonds. Provide a real-world
example to illustrate your answer.
When interest rates rise, existing bond prices fall, since new bonds pay more attractive rates.
Example: If you hold a 5% bond and rates rise to 7%, your bond is less valuable in the market.
- What is term structure of interest rate?
It shows the relationship between interest rates (or yields) and bond maturities. Often illustrated with a yield curve.
- What factors determine the required return on bonds?
Credit risk
Inflation expectations
Interest rate risk
Liquidity
Tax considerations
Time to maturity
- Analyze the impact of inflation on bond investors.
Inflation erodes the purchasing power of fixed coupon payments, reducing real returns.
Higher inflation expectations generally lead to higher required returns, lowering bond prices.
- What are bond ratings and why are they important?
Assigned by agencies (e.g., Moody’s, S&P) to indicate credit risk.
Important because they influence the required return and investor confidence.
- Compare and contrast investment-grade bonds and junk bonds in terms of risk, return, and
typical investors. Why might an investor choose a high-yield bond despite the risk?
Investment-grade: Lower risk, lower yield, preferred by conservative investors.
Junk bonds (High-yield): Higher risk of default, higher yield, attract investors seeking greater returns.
- Discuss the pros and cons of investing in government bonds versus corporate bonds,
considering factors such as risk, return, tax treatment, and liquidity.
Government Bonds:
Pros: Low risk, tax advantages (some are tax-exempt), high liquidity.
Cons: Lower returns.
Corporate Bonds:
Pros: Higher returns.
Cons: Higher credit risk, possibly less liquidity.
- Please rank the following types of bonds based on their average yields (from the lowest to the
highest yield): a BBB rating 10-year corporate bond; an AAA rating 10-year corporate bond; and
a 10-year Treasury bond.
10-year Treasury bond (lowest yield, safest)
AAA-rated 10-year corporate bond
BBB-rated 10-year corporate bond (highest yield, more risk)
- What is a mortgage-backed security (MBS)? Who are the typical issuers of MBS in the U.S.
Market?
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is created by pooling together a large number of home loans (residential mortgages) and selling them to investors. These investors receive periodic payments derived from the principal and interest payments made by the homeowners on the underlying mortgages.
How it works:
Banks or mortgage lenders originate home loans.
These lenders then sell the loans to institutions (called “issuers”).
The issuer bundles the loans into a mortgage pool and creates securities (MBS).
These MBS are then sold to investors who receive income as homeowners make payments.
This process is known as securitization, and it helps lenders free up capital to issue more mortgages, increasing liquidity in the housing market.
Types of MBS:
Pass-through securities: Homeowners’ mortgage payments (less servicing fees) are passed through to MBS holders.
Collateralized Mortgage Obligations (CMOs): Structured MBS that divide cash flows into tranches with different risk and return characteristics.
Typical Issuers of MBS in the U.S.:
Government-sponsored enterprises (GSEs):
Fannie Mae (Federal National Mortgage Association)
Freddie Mac (Federal Home Loan Mortgage Corporation)
These issue agency MBS, which are not backed by the full faith and credit of the U.S. government, but are considered low-risk.
Ginnie Mae (Government National Mortgage Association):
Issues government-backed MBS that are explicitly guaranteed by the U.S. government.
Private institutions (private-label issuers):
Investment banks and financial firms issue non-agency or private-label MBS, which can include subprime loans and carry higher risk.
- Why did some highly-rated MBS contribute to the 2008 financial crisis?
The 2008 financial crisis was triggered in part by the collapse of the U.S. housing market, and highly-rated mortgage-backed securities (especially those containing subprime loans) played a central role. Here’s how:
Key Factors:
Risky underlying assets (subprime mortgages):
Many MBS were backed by subprime mortgages, which were loans made to borrowers with poor credit histories, little income verification, and high default risk.
As home prices rose during the early 2000s, lenders lowered their standards, issuing adjustable-rate and interest-only mortgages that were unsustainable once rates increased.
Misleading credit ratings:
Credit rating agencies (like Moody’s, S&P, and Fitch) gave AAA ratings to many MBS and CDOs (collateralized debt obligations) that included subprime loans.
These ratings suggested the securities were nearly risk-free, even though the underlying assets were highly risky.
Complexity and opacity:
Many MBS were repackaged into structured products like CDOs, making it difficult for investors to understand what they were buying.
Risk was hidden and spread throughout the financial system, making it hard to assess the real exposure.
Overconfidence and moral hazard:
Banks, investors, and rating agencies assumed housing prices would keep rising.
Mortgage originators had little incentive to ensure loan quality since they would offload the risk through securitization.
Massive defaults and falling home prices:
When adjustable-rate mortgages reset and housing prices began to fall, many subprime borrowers defaulted.
This caused the cash flows behind the MBS to dry up, making even AAA-rated MBS toxic.
Investors lost confidence, markets froze, and financial institutions that held or insured these securities suffered massive losses (e.g., Lehman Brothers, AIG).
- How will the change in required return influence the price of a stock? How will the dividend
growth rate influence the price of a stock?
Stock prices are sensitive to both the required rate of return and the dividend growth rate, especially in models like the Dividend Discount Model (DDM).
Required return (r): If the required return increases, the present value of future cash flows (dividends) decreases, and stock price falls. Conversely, if the required return decreases, stock prices rise.
Dividend growth rate (g): A higher expected dividend growth rate increases the future value of dividends, leading to a higher stock price. A lower growth rate results in a lower stock price.
In the Dividend Growth Model:
P=D1/r−g
Where P = stock price, D1 = dividend next year, r = required return, g = growth rate.
- What assumptions does the Dividend Growth Model make about dividend growth?
The Dividend Growth Model (DGM)—also called the Gordon Growth Model—makes the following assumptions:
Dividends grow at a constant rate (g) forever.
The growth rate is less than the required return (g < r).
The company pays dividends and will continue to do so indefinitely.
The model works best for mature, stable companies with predictable dividend growth (e.g., utilities or large blue-chip firms).
- Based on the dividend growth model, what are the two components of a stock’s rate of return?
What is capital gain? What is dividend yield?
Under the Dividend Growth Model, a stock’s total return (r) consists of two parts:
R = Dividend Yield + Capital Gains Yield
Dividend Yield = D1/P Represents income investors receive from dividends.
Capital Gains Yield = g: The expected rate at which the stock’s price will grow.
So, if a stock yields 3% in dividends and is expected to grow at 5% annually, the total expected return is 8%.
Capital gain: The price appreciation of a stock over time. For example, if you buy at $50 and sell at $70, your capital gain is $20.
Dividend yield: The annual dividend expressed as a percentage of the stock’s current price.
- What are the differences between common stocks and preferred stocks in terms of the rights of
stockholders and dividend characteristics?
Feature Common Preferred Stock
Voting Yes no
Dividend none Fixed dividends
CoA Last in line Priority over common
Growth High potential Limited capital
Risk Higher risk Lower risk
- What are the advantages and disadvantages for a company to go public?
Advantages:
Access to Capital: Raise large amounts of money to fund growth, R&D, acquisitions.
Liquidity: Existing shareholders can sell their shares.
Publicity: Increases visibility and credibility with customers and partners.
Employee Compensation: Stock options attract and retain talent.
Disadvantages:
Cost: IPO and compliance costs (legal, accounting, reporting) are high.
Disclosure: Must publicly share financial and operational information.
Loss of Control: Dilution of ownership and influence of outside shareholders.
Short-term Pressure: Must meet quarterly expectations, which may hurt long-term goals.
- How can an IPO impact the original owners and employees of the company?
Original Owners:
Pros: Potential windfall from selling shares at high valuations; prestige and liquidity.
Cons: Reduced ownership, control, and subject to market volatility.
Employees:
Pros: Stock options may become very valuable (creating “paper millionaires”); prestige.
Cons: Lock-up periods restrict immediate selling; job pressure may increase post-IPO.
- What is the difference between the primary and secondary markets in the context of an IPO?
Primary Market:
This is where the company sells shares to investors for the first time during the IPO.
Funds go directly to the company to finance operations or expansion.
Secondary Market:
After the IPO, shares are traded between investors on exchanges like the NYSE or NASDAQ.
The company doesn’t receive any money from these transactions.
- Among the following types of investments, small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, and U.S. Treasury bills, which type of
investment provided the largest average return in the past 90-year period? Which provided the
lowest average return?
Based on long-term historical data (such as from the Ibbotson SBBI Yearbook):
Largest Average Return:
✅ Small-Company Stocks
These tend to outperform over the long term because they are riskier, less liquid, and have more growth potential, which investors demand a premium for.
Lowest Average Return:
❌ U.S. Treasury Bills (T-Bills)
These are short-term, government-backed securities with very low risk, but also the lowest return, often just above inflation.
Average Annual Returns (historical estimates, 1926–2020s):
Small-company stocks: ~11–12%
Large-company (S&P 500) stocks: ~9–10%
Long-term corporate bonds: ~5–6%
Long-term government bonds: ~4–5%
U.S. Treasury Bills: ~3–4%
