Ch. 5 Yield (total return) = Dollar inc + (end-beg) beg. Value Risk of Return = r= Risk Free rate + Risk Prem r=rRF+DRP+LP+MRP Risk Free Rate = rRF = r* + IP -effects of int rates on PV/Price of securities: int goes up, value of bonds goes down, stock goes down (NPV) Prices -factors that influence int rates/yield curve 1. production opportunities-return avail w/in an economy from inves. In productive asset; higher prod opp, higher return 2.
Time preferences for consumption 3. Risk-change that fin asset won’t earn return promised 4. Inflation-price goes up over time 5. Federal reserve (monetary policy)-slow(control)growth and int rates go up; loosens money supply, int goes down (easy fed policy) 6. Deficit (fiscal policy)s- gov’t borrows, int goes up; larger the deficit, the higher the int 7. Int’l business-trade deficit goes up, int rates go up 8. Business activity-goes up, int goes up nom risk free rate-rate of int on sec that is free of all risk (Tbil) -real risk free ratio-int rate that would exist on risk free sec if inflation is expected to be 0 during invest. Pd -inflation prem-prem for expected inflation that investors add to real-risk free rate of return -default risk prem-diff btwn 1 int rate on a US T-bond & corp bond of = maturity&marketability; wont meet obligations -maturity prem-longer maturity, higher risk term structure of int rates-relationship btwn LT&ST rates -yield curve-relationship btwn LT/ST rates -normal yield curve=LT higher than ST rates; upward -expectations theory-shape of yield curve depends on expectations concerning future inflation rates -mkt segm theory-every borrower&lender has a preferred maturity&slope of yield curve depends on supply of dem for funds in LT mkt relative to ST mkt -open mkt ops-fed reserve buys/sells treasury sec to expand/contract US money supply Ch. 6 Bond Valuation bond-LT contract under which borrower agrees to make payments of int and principal on specific dates to bondholder -coupon rate – total int paid each year, stated as % of bond’s face value -bond trade @ discount-required rate of return is HIGHER than coupon rate -bond trade @ prem – rate of return is LOWER than coupon rate -when mkt value of debt is the same as its face value, it’s sold at par value -bond ratings-based on qualitative&quantitative factors; fin strength, collateral provisions, seniority of debt, restrictive covenants, etc – AAA & AA are extremely safe invest. Grade bonds-lowest rated bonds that many banks and other institutional investors may hold by law -bond’s ratings is an indicator of all its default risk; most are purchased by institutional investors who are legally restricted to investments -changes in ratings affect firm’s ability to borrow LT capital and cost of that capital -types of debt: short term 1. Treasury bills-issued by gov’t to finance its operations & programs 2. Repurchase agreements-firm sells some of its fin. Assets to another firm w/ a promise to repurchase the security @ later date 3.
Federal funds-overnight loans from one bank to another 4. Banker’s acceptance-issued by a bank that obligates the bank to pay a specified amt @ some future date 5. Commercial paper-discounted instrument that is a type of promissory note; “legal” IOU 6. Cert. of Deposits (CDs)-int earning time deposit @ a bank or other fin intermediary trad-issuing company, specified time pd negotiable-traded to other investors, can be redeemed whenever 7. Eurodollar deposit-deposit in a bank outside the US that is not converted into currency of foreign country 8.
Money market mutual funds-pools of funds managed by invest. Companies that are primarily invested in ST fin assets LONG TERM DEBT 1. Term Loans-obtained from bank or insurance company, borrower agrees to make series of payments consisting of int + principal 2. Bonds-LT contract under which borrower agrees to make payments of int + principal on specific dates to bondholder -gov’t bonds-issued by fed,state,local govts municipal –issued by state & local gov’t 1. Rev- projects that will generate rev 2.
General ob-backed by gov’ts ability to tax its citizens ( taxes); exempt from fed taxes -corporate-issued by corps, advertised, offered to public, sold to many investors -mortgage-pledges certain tangible assets as security or collateral; 1st gets all before 2nd -debenture-unsecured bond; provides no lien, claim -subordinated deb-ranks below other debt w/ respect to claims on distributions -income bonds-pay int only when firm generates sufficient inc to cover int payments -putable-can be redeemed @ BH option indexed-int payments based on inflation index to protect holder from loss (int goes up, inflation up) -floating rate-int rate fluctuates w/ shifts in general level of int rates -zero coupon-pays no annual int but seels @ discount below par -junk bond-high risk, high yield bond, used to finance mergers, leveraged buyouts -foreign debt-debt sold by foreign borrower but is denominated in currency of country in which issue is sold -eurodebt-used to designate any debts sold in country other than the one whose currency it’s denominated -total ret = coupon (int) + cap gains yield (Chngprice) original price yield to maturity-ave rate of return earned on bond if it’s held to maturity -yield to call – avg rate of return earned on a bond if it’s held until first call date -semi-annual compounding-bond pay $50 int every 6 months rather than 100 at the end of each year. Simple rate of int is 8% w/ semi-annual compounding, value of bond when there are 14 years remaining –N=28 (14×2), I=4(8/2), INT=PMT=50(100/2),M=FV=1000, PV? 1166. 63 -changes in bond value – whenever the going roate of int (rd)=coupon rate, a bond will sell @ its par *an in int rates will cause price of outstanding bond o fall *a in int rates will cause price to rise *mkt value of a bond will always approach its par value as its maturity date approaches -bond yield=current(int)yield+cap gains yield (INT/Vbeg) +Vend-Vbeg/Vbeg -int rate reinvestment rate risk-risk that inc from bond portfolio will vary bc CF have to be reinvested @ current (lower) mkt rates [email protected] time bond is issued, coupon rate is set @ a level that will cause mkt price of bond = par value -rd-avg rate of return investors requires to invest in bond -INT=dollars of int paid each year = coupon x maturity coupon rate-int paid each year, stated as % of bond’s face value -bond covenants: bond indenture-formal agreement btwn issuer of a bond/bondholders; call provision-gives issuer the right to redeem bonds under specific terms prior to normal maturity date; sinking fund-facilitates orderly retirement of bond issue; amortize loan (randomly call for redemption or purchasing required amt of bonds); convertible-bond into shares Ch. 7 Stock -p. stock-hybrid security; similar to debt/c. stock *higher priority claim than c. stockholders par value-has par value; liquidation value/pref; div is stated as % of par value *cumuli. Div-any p. div not paid in previous pds must be paid before c. div can be distributed *has no specific maturity date *has priority over c. holders, but NOT debt holders w/ earnings & assets; div paid to p. holders first *has no voting rights *convertibility to c. stock @ conversion price *call provision-redemption of p. stock; call prem: amt in excess of par value that a company must pay when it calls security *sinking fund: call for repurchase&retirement of a given % of p. tock each yr; adds maturity *participating-rare type; participates w/ c. stock in sharing firm’s earnings -c. stock-“owners” of firm bc investors have certain rights&privleges associated w/ property ownership *doesn’t have par, but can be assigned *div-no obligation to pay c. stock div *inc stock-traditionally pay large, constant div each yr *growth stock-pay little or no div; help fund growth opp *has no specified maturity; perpetual *can be paid div only after int on debt & p. div are paid *has voting rights preemptive right-provision in corporate charter or bylaws that gives CSH the right to purchase new issues of c. stock on a pro rata basis; protects power of control of current SH; protects SH against dilution of value that would occur if new shares were sold at low prices *types of c. stock-classified: given a special signation (class A/B) to meet special needs of company; voting 5 yrs later; founders’ shares-stock owned by firm’s founders that has sole voting rights but pays out restricted div for a specified # years -int’ equity instruments-Am.
Depository Receipt (ADRs)-certificates that represent ownership in stocks of foreign companies that are held in trust by bank located in company where stock is traded; foreign equityeurostock-traded in countries other than the home country; yankee stock-stock issued by foreign companies&in the US -valuation of stock-div discount model-stock’s value found by determining the PV of expected future CF -mrk price value-p[email protected] stock currently sells in mkt -growth rate-expected rate of change in div per share -required rate of return-min rate of return the SH consider acceptable on c. tock -div yield-expected div divided by current price of share -cap gains yield-change in price during a given yr /by price @ beg of yr -expected rate of return0raote of return that an indiv SH expects to receive on a c. stock=div yield+cap gains yield -P/E Ratio-current mkt price of stock/earnings per share; higher the P/E ratio, the more investors are willing to pay for each dollar earned by firm; P/E too low, price goes up, P/E too high price goes down -econ value added-earnings generated by a company must be sufficient to compensate its suppliers of funds *EVA > 0, firm value should increase use to determine max div per share that can be paid to SH before value is threatened EVA/#of outstanding share -changes in stock prices-investors change rates or return they require to invest in stocks, expectations about the CF associated w/stock change -stock prices move opposite in rates of return, but move in same direction as changes in CF expected from stock in future -if demand for higher return to invest in stocks, prices fall -equilibrium ordinarily exists for any given stock, required returns (r)&expected returns are = Ch. Risk and Return -risk-chance that an outcome other than expected one will occur; greater the variability of possible outcomes, riskier the investment -probability distribution-listing all possible outcomes or events, w/ probability assigned to each outcome -measuring stand alone risk – STD DEV-measure of tightness, variability of a set of outcomes; smaller the SD, tighter the prob distribution and lower total risk associated w/ invest. CV-measure for evaluating risky investment = risk/return -expected rate of return-measured by computing weighted avg of outcomes using probabilities as the weight; don’t = any of the possible prob distributions -portfolio risk-holding investment as a portfolio is less risky than holding some invest. Itself bc risk can be spread -expected return on port-weighted avg expected return on stocks held in portfolio -portfolio risk-diversification – reduction f stand alone risk of indiv.
Invest by combining it w/ other invest in portfolio -correlation coefficient-measure of degree of relationship btwn 2 variables -firm-specific risk (diversifiable)-part of a security’s risk associated w/ random outcomes generated by events or behaviors, specific to firm; lawsuits, strikes, etc -mkt (undiversifiable) risk-associated w/ econ, mket facots that systematically affect all firms to some extent; war, inflation -relevant risk-can’t be diversified away, security’s mkt risk -beta –measure of stock’s sensitivity to mkt fluctuations; measure of extent to which the returns on a given stock move w/ stock mkt (covariance to mkt) -greater the risk, higher the required return -add low beta stock, decrease risk -capital asset pricing model (CAPM)-determine required rate of return; based on proposition that any asset’s return should be = to risk free return + RP that reflects nondiv. Risk -secureity mkt line-line that shows relationship btwn risk as measured by beta and required rate of return for indiv sec. slope reflects degree of risk aversion in economy *greater the aversion to risk, steeper the slope, greater the RP for any stock, higher the required rate of return on stocks -risk aversion-mkt risk prem depends on degree of aversion that investors on avg have to risk, reflected in slope of SML -as risk aversion goes up, RP goes up, slope of SML goes up -systematic (nondiversifiable,mkt,relevant risk): *int rate risk-when int rates change, values of invest. Change, and rate @ which funds can be invested also changes *inflation risk-primary reason that int rates change is bc investors change their expectations about future inflation *maturity risk-LT invest. Experience greater price reactions to int rate changes than do ST invest *liquidity risk-reflects fact that some invest.
Are more reasily converted into cash on short notice @ reasonable price *exchange rate risk-multinat’l firms deal w/ diff currencies, rathe @ which currency of one country can be exchanged into currency of another *political risk-any action by gov’t that reduces value of invest -unsystematic risk (diversifiable, firm-specific) *business risk-risk hat would be inherent in firm’s operations if used no debt; labor conditions, safety, quality of mgmt. *financial risk-associated w/ how firm is financed –CR risk *default-part of fin risk –change firm wont be able to service existing debt -combined risk (sys/unsys): *total risk-combo of sys/unsys; stand alone risk bc its risk investor takes if purchases only 1 invest *corporate risk-riskiness of firm w/out considering effect of SH diversification; based on combo of assets held by firm