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Final Exam
Terms in this set (106)
Discounted Cash Flow Valuation
Valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF is higher than the current cost of the investment, the opportunity might be a good one
Value (of an investment)
Stock, bond, mortgage, etc.-Is the present value of its expected cash flows, discounted (reduced) for their risk and timing
Expected cash flows
The most likely cash payments (dividends, interest, capital gain or loss) that you can expect (not hope) to receive.
Discount
Multiply a number by a rate less than one
Discount Rate
The rate used to calculate the present value of a future cash payment. A function of time and risk: DR=f(time, risk)
Discount Factor
The equation 1/(1+r), values that give the present value of a dollar that you are expected to receive at some time, n, in the future, discount at a rate, r.
Present Value
Of an investment is the sum of the expected cash flows multiplied their respective discount factors. The amount that a future sum of money is worth today given a specified rate of return.
Risk Premium
The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors who tolerate the extra risk -compared to that of a risk free asset-in a given investment
Level Cash Flows
The interest rate and cash flows associated with the loans, mortgages, and annuities are fixed and do not change
Loan
Obligation under which a person borrows money from a lender
Terms
Of the loan state an interest rate and a repayment of amortization schedule.
Home mortgage
An obligation under which a person borrows money from a bank and uses the proceeds to purchase a house or condominium
Life annuity
A contract sold by pension funds and life insurance companies
Pays a specified amount of money per year
Amortization schedule more complex than loands or mortgage
Investor makes a single payment or multiple payments then withdraws funds upon her retirement
Project
or venture is an investment to produce a product or provide a service that will generate money in the future
Cash Inflows
Additional revenues coming into the company as a result of the project
Cash Outflows
Additional expenses being spent by the company as a result of the project
Bond
Debt instrument, Corporations, the US government and municipalities issue bonds
They are payable from taxes from the Us government or the general revenues of a corporation
Stock
Represents ownership interest in a corporation
The cash inflows consist of dividends and increase or decrease in stock price
There is no maturity associated with stocks the life is infinite
The risk of a stock is hard to quantify, making it difficult to determine the proper discounting rate
Capital Budgeting
-The process of planning and managing a firms long term investments in projects and ventures
-It estimates the amount, timing, and risk of future cash flows
-Starts with estimation of incremental cash flows from a project; creates a time line of expected cash flows; and compares the present value of the cash flows with the cost of a project
Net Present Value
Difference between the value and cost of investment
-The value of any project is equal to the present value of its expected cash flows, discounted for risk and timing
-NPV Rule-Invest in projects if NPV is positive. Reject if NPV is negative
Internal Rate of Return
-Rate of return expected to be earned on a project
-Discounting rate that makes the net present value of an investment equal to zero
-if the investment has IRR that is higher than some pre-determined required rate of return, accept investment
Payback Period
Length of time for the return on an investment takes to cover the cost of the investment
-Involves only gross cash flows and not discounted cash flows
-Accept the investment if its payback period is less than a predetermined number of years;
-Reject the investment if its payback period is greater than the predetermined number of years
Book Rate of Return
Accounting ratio calculated by dividing the companies accounting profits by the book value of the companies assets
-Rule: Accept the investment if its book rate of return exceeds a predetermined target book return
-Reject the investment if its book rate of return is less than a target book return
Profitability Index
The NPV of an investment, divided by its cost
-Used to identify projects that will receive the best return associated with the amount of dollars invested by ranking the projects of PI
-PI Rule is:
-Accept the venture with the highest profitability index first; then accept ventured with lower and lower positive PI's until the projects expend the capital budget; do not accept projects with a negative PI
CAPM-The trade off between return and risk
Trade-off between the expected return on an investment and its risk.
Low risk treasury bills have lower expected returns (2-4%). Stocks (large price volatility) have higher expected returns (6-10%).
Risk measured by price or return volatility. More price/return movement--greater risk
A rational investor requires a higher expected return to accept additional risk
CAPM describes the trade off-Page 1 of chapter 12
Rate of return
(cash payment+change in price)/Price Paid;
Dividends
Quarterly payments made on some stocks (ownership)
Interest
Semi-annual payments made on bonds (debt)
Change in Price-Capital gain or capital loss
realized-you sell your asset and incur gain or loss
unrealized-you continue to own your asset
If realized, the gains or losses are taxed
Long-term
gains and losses are taxed at a lower rate (20%)
Short-Term
gains and losses are taxed at a higher rate (35%)
Risk
Measured by the possible range of returns around an expected return; Measured by stdev;
Expected return on stock i(Ri)=
Risk free rate (Rf)+the stocks beta (Bi) multiplied by the market risk premium--the return on the market (Rm) minus (Rf)
E(Ri)=Rf+Bi*(Rm-Rf)
Why is beta a measure of market magnification?
A stock with a beta of 2 will tend to double market movements (up or down)
A stock with a beta of 0.50 will tend to have movements (up or down) equal to 1/2 the market
Unsystematic Risk
Firm specific risk-risk that affects the return of that firm or industry only. Can be diversified away. Risk you are NOT paid to take
Firm specific risks average out to be 0 if an investor holds a diversified portfolio
Systematic Risk
Market related risk as measured by Beta. Risk that CAN NOT be diversified away. Risk you are paid to take. Risk of the stock market caused by economy, taxes, and other market factors
Risk Premium
The amount by which an investment is expected to outperform T-Bills
Market has averaged about 12% a year
T bills averaged 4% per year
Market risk premium is 8%
(Rm-Rf)
Alpha
Measures performance- Also called the ZERO TALENT LINE
A positive alpha is GOOD and a negative alpha is NOT SO GOOD
Observed return of asset-Expected return of asset
Efficient Market
A market where all investments are accurately priced. This means there are no good investments and there are no bad investments, Each investment offers an expected return to match its level of risk.
An important principle of finance: Efficient capital markets
Asset prices react very quickly to the receipt of new information. New information is random. Can be good or bad.
Quick reaction of many market participants to new information tends to drive prices to their correct level
Random Walk Hypothesis
A path a variable takes where the future direction of the path (up or down) can't be predicted solely on the basis of past movements.
If stock markets are efficient, share prices react immediately to news. There is no predictable trend implied by a gradual market reaction. In an efficient market, share price changes are random.
Weak form efficiency
Stock prices reflect the information contained in the history of past stock prices and trading volume
Implies daily stock price changes are independent;
Useless to try to detect and exploit trends in stock prices
Semi-Strong form efficiency
Stock prices reflect all publicly available information.
Implies stock prices react quickly to new info and prevents investors from earning abnormal returns
Strong-form efficiency
Stock prices reflect all information, including information not available to the investment community
Behavioral Finance
Academicians who specialize in the field of BF, have challenged Modern Portfolio theory's assumption that investors are rational and markets behave rationally
Behavioral theorists have conducted studies that show that stock markets were not efficient and people and markets, at times, behave irrationally.
The fama and french study
Fama and French study compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics.
The study showed, among other things, portfolios of stock with a high book value (BE) to market value ratio consistently outperformed portfolios with low (BE/ME) ratios and called to question the validity of efficient capital markets.
Finds that stocks with low p/e ratios outperform stocks with high p/e ratios;
Stocks with small market caps outperform stocks with large market caps.
Other researchers find roughly the same results.
Less Technical Evidence from the real World
Evidence indicates stock price changes are independent
Evidence indicates stock prices react quickly to news and excess returns are arbitraged away
Evidence From Mutual Funds
Studies of Mutual Funds using gross returns have shown that mutual funds do no better than to lie on the risk-return line (alpha of zero)
Net returns (gross returns less fees) give a negative alpha
In an efficient market, funds wit the lowest fees have the greatest alpha
Evidence on individual investors
A study of 60K individual accounts at a discount brokerage firm showed that trading costs negatively and significantly affect the returns of market participants
Investors can improv returns by reducing transactions costs to the lowest level possible
Bond
A debt financial contract under which the issuer is obligated to make periodic interest payments and repay the principal at some predetermined time.
The legal agreement between the issuer of the bonds and the investors is the indenture
The amount that is originally borrowed and the amount that is repaid when the bonds mature and the principal payment is due is known as principal value, or par amount or a maturity value.
Coupon rate
Interest rate on a bond is the rate, expressed on a percentage basis, at which interest accrues or is paid by the issuer to the owner of the bond.
Interest rate setting structures vary and can be broadly classified into two categories
Fixed rate structures
Floating rate structures
Interest rate setting structures affect the value of a bond
The coupon rate and payments are fixed over the life of the bond and the investors and the issuer are certain of the payments
Fixed Rate Par Bond
The issuer issues the bond at par value and pays fixed interest semi annually on predetermined dates and repays the full par value of the bond on maturity
Fixed Rate Discount Bond
the bond is issued at a coupon rate that creates a market value of less than par at the time of pricing, and offering an yield that is higher than the coupon rate
Fixed Rate Premium Bond
the issuer will market a bond with a coupon and interest rate that creates a market value of more than par at the time of pricing, and an offering yield that is lower than the coupon rate
Floating Interest Rate
-In floating interest rate instruments, initially interest rate setting mechanisms were based upon some interest rate index or level of a risk free security
-Over the years, rate setting mechanisms have been developed that are designed to create a bond that always trades at or near par value
-Historically, the floating interest rates have been significantly lower than the rates on fixed-coupon bonds. However, the issuer retains the interest rate risk inherent in a bond issue.
Bond Valuation and Interest Rates-Security
The sources of security on a bond issue can vary a great deal, and will affect the credit rating and creditworthiness of the issue
Securities that are issued by the U.S. Government are usually assumed to be risk-free
Municipal bonds may be secured in a variety of ways such as by the issuer's taxing power, revenues and credit enhancement devices
Corporate Debt
is most often an unsecured promise by the corporation to pay its debts. Sometimes the bonds will be secured by collateral or a mortgage on a particular property or piece of equipment
Asset-backed securities
are secured by the sponsor who structures the financing and usually purchases credit enhancement
Call Option
Issuer's option to redeem bonds prior to their stated maturity, at a pre-determined price above par value
An investor that owns a callable bond is subject to considerable uncertainty about cash flows on its callable bonds and hence will require a higher yield on callable bonds than on comparable non-callable bonds
Call Premium
The excess amount of the call price above the par value
Four types of risk involved while investing in fixed-rate of fixed-coupon debt obligations
Default
Reinvestment
Prepayment
Interest Rate
Default Risk
the risk that the bond will not pay interest or principal when due
Reinvestment Risk
-the unknown rate at which cash inflows may be reinvested.
-is the risk that arises from reinvesting the periodic interest payments on fixed-rate bonds
-An investor receiving payments over the life of a coupon-bearing bond faces the risk of reinvesting coupon payments at uncertain future interest rates than may be lower than the yield on the bond
-The yield to maturity on coupon bonds depends significantly on the reinvestment rates
Prepayment Risk
is the risk that a bond will be retired or redeemed at a time earlier than its maturity date
Interest Rate Risk
the risk that a change in market interest rates will affect the value of the bond
The price volatility of a bond is the extent to which its price changes with fluctuations in market levels of interest rates
Bond prices and yields move in opposite directions, other things being equal. The magnitude of price movements will differ based on specific bond characteristics
The longer the maturity of a bond, the higher the volatility of bond prices, the greater the risk
The lower the coupon on a bond, the higher the price volatility, the greater the risk
Spread to treasuries
All taxable fixed-rate debt that is issued or traded in the US capital markets is priced at what is called spread to treasuries, which is the measure of default risk on an asset-backed transaction or a specific companies debt.
The interest rate, or yield, of all debt is vitally dependent on the risk free rate associated with the comparable maturity
The difference between the yield on a non-callable US treasury bond and the yield on a non-callable corporate bond with an identical maturity is called the spread to treasuries and is a measure of the default premium associated with the corporate bond.
The spread to treasuries is a function of the type of industry the issuer belongs, the credit rating of the corporate bond and a function of the time to maturity of the bond.
Senior Debt
The most secure debt issued by a company. In the event of liquidation in bankruptcy, the most senior debt is paid first and whatever is leftover is distributed to the rest of the debt holders
Subordinated Debt
Is debt that follows senior debt in line for claims on cash flows and assets upon liquidation
Duration
The price volatility of a debt issue is measured using duration
The duration of a bond is measured in units of time (for example, 7.3 years).
In the simplest case, the duration of a zero coupon bond is equal to its current time to maturity
The higher the current coupon payments, the lower the price volatility and the shorter the duration
Yield Curve
The yield curve is the relationship between the yields and the maturities on Treasury securities.
The yield curve usually is positively sloped which means that investors require higher returns for longer maturity Treasury securities. This is because the prices of longer maturity bonds are more volatile and therefore are viewed as being riskier than shorter maturity securities
Municipal Bonds
Municipal bonds are debt instruments issued by states, cities, municipal authorities and other entities
Municipal bond interest income is exempt from federal and certain state and local income taxation
Convertible Bonds
Corporations also issue bonds known as convertible bonds that usually pays a fixed-rate of interest, and after a certain period of time, can be converted into a fixed number of shares of the issuing corporation
Yield
The yield or return that an investor should expect to receive on a financial asset such as a bond is a function of a number of factors, the most important of which are:
- The time value of money
- The default risk associated with a particular security
- The liquidity premium and other bond specific factors peculiar to the financial asset, such as call provisions
Pure Expectations Hypothesis
The yield curve can be analyzed as a series of expected future short-term interest rates that will adjust in a way such that investors will receive equivalent holding period returns
Thus the expected average annual return on a long-term bond is the compound average of the expected short-term interest rates
Thus an upward-sloping yield curve means that investors expect higher future short-term interest rates and a downward-sloping yield curve implies expectations of lower future short-term rates
Liquidity Preference Hypothesis
According to the liquidity preference theory most investors prefer to hold short-term maturity securities and hence in order to induce investors to hold bonds with longer maturities, the issuer must pay a higher interest rate as a liquidity premium
Thus under this theory, long-term rates are composed of expected short-term rates plus a liquidity premium which increases with time to maturity
This theory implies an upward-sloping yield curve even when investors expect that short-term rates will remain constant
Market Segmentation Hypothesis
The market segmentation hypothesis or the preferred habitat hypothesis, recognizes that the market is composed of diverse investors who have different preferred habitats i.e. short term and long term investments for the investment requirements
In order to induce investors to move away from their preferred position on the yield curve, an issuer must pay a premium. Thus any maturities that do not have a balance of supply and demand will sell at a premium or discount to their expected yields and the shape of the yield curve is dependent upon demand and supply
Nominal Interest Rate
is the actual rate of return or yield associated with an investment (not adjusting for the effect of inflation or deflation)
The real rate of interest
is defined as the difference between the nominal rate of interest and the rate of inflation
Example: If inflation is 2% and nominal interest rate of 10 year Treasury bond is 6%, then:
real rate of interest = 6% - 2% = 4%
Perpetuity
An asset that has a stream of even cash flows that continue to infinity
The value of a perpetuity is calculated by dividing the level annual cash flow associated with the perpetuity by the discounting rate:
Value of a Perpetuity =Annual Cash Flow/Discounting Rate
Return to stockholders is
Dividends + change in stock price/beginning stock price
Technical Analysis
Technical analysts believe that stock prices are influenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company.
Fundamental Analysis
According to Fundamental Analysis approach, the company's current and future operating and financial performance determine the value of the company's stock
The assumption underlying this approach is that a company's stock has a true or intrinsic value to which its price is anchored. When there is an price divergence, the price over time will gravitate to its intrinsic value.
To assess a company's prospects, fundamental analysts evaluate overall economic, industry and company data to estimate a stock's value
Modern Portfolio Theory
Efficient capital markets is a cornerstone of MPT and is the belief that stock prices always reflect intrinsic value, and that any type of fundamental or technical analysis is already embedded in the stock price.
As such, MPT devotees tell investors not to bother to search for undervalued stocks but instead to pick a risk level that they can live with and diversify holdings among a portfolio of stocks.
However empirical evidence shows that there is value to careful stock selection.
Stock Valuation
The value (current dollars, PV, hard cash) of any financial instrument (stock, bond, mortgage) equals the present value of its expected cash flows (think "real profits"), discounted (think "reduced") for risk and timing.
Stock Valuation depends most on profits,
interest rates and risk.
4 Steps for Discounted Cash Flows
Step 1: Forecast Expected Cash Flows (think "real profits")
Step 2: Estimate the Discount Rate (think "interest rates")
Step 3: Calculate the Enterprise Value of the Corporation
Step 4: Calculate Per Share Stock Value
Buy Decision
If the stocks value is greater than a stocks price by (X)%, buy it
Sell Decision
If the stocks value is less than the stocks price by (Y)%, sell it.
Diversification
Costless way to reduce risk
Efficient Frontier
Achieving the highest return for certain level of risk is known as investing on the efficient frontier
Hedging
Sacrifice gain to protect against loss
Three types:
Future Contracts, Forward Contracts, Swaps
Some terms relating to hedging:
Hedgers and speculators
Long position and short position
Value and size of a contract
Spot price and forward price
When an investor hedges, he fixes the sales price for the asset and gives up any upside gain for offloading the risk of loss.
Future Contracts
A forward contract with standardized terms that trades on an organized exchange
Forward Contracts
A written agreement between two parties that is not traded on an organized exchange
Swaps
An agreement between two or more parties to exchange sets of cash flows over a period of time
Interest swap and currency swap
Insurance
Pay a premium to protect against loss
Insurance contracts
-Cap-Limitation of the amount of money paid under a claim
-Deductibles
Option
-Financial assets that have characteristics similar to insurance contracts
-Represents the right to sell or purchase an asset at a fixed price at a fixed time in the future
Strike Price
Also known as exercise price, predetermined.
Expiration Date
After which the option can no longer be exercised
Call Option
Call option contracts enable the owner to buy an asset
Put Option
Put option contracts enables the owner to sell an asset
Intrinsic Value of Option
The amount the option is in the money and is the difference between the current price and the strike price of the option.
Time Value
Reflects expectations of an option's profitability associated with exercising it at some future point in time
Derivative Securities
Value derives from or is based on
-The value of a simple security or
-The level of an interest rate or
-Interest rate index or
-Stock market index
Delivery occurs sometimes many years into the future, and buyer or seller can offset transactions
Value Call Option = Value Callable Bond - Value Non-Callable Bond
Derivative securities often are more sensitive to price or yield changes, and sometimes are more leveraged
Attractive to hedgers
Can backfire for speculators
Equity and Debt Components
Embedded with the characteristics of a simple stock or bond.
The bond component can be fixed-rate, zero-coupon, or amortizing.
Option or price insurance components
Interest rate floors and caps, call and put options.
Zero or positive values are associated with these components for the owner of the option.
Zero or negative values are associated with these components for the writer of the option.
Hedging or price-fixing components
Forward, futures contracts, interest rate and currency swap
The value of these components may be positive or negative, depending on movements and shifts in yields, currency levels, or spot prices.
The relative value at the time of issuance of the derivative security is zero.
Generally have little upfront cost and are the most efficient type of hedging contract.
The concept of arbitrage and the law of one price
Investors constantly check the cash and derivative market to look for arbitrage opportunities
The law of one price dictates that the futures price of an asset and the spot price of the asset must be the same on the day future contracts expire
Summary
Management of risk
Risk associated with the returns of financial assets
Diversification, hedging and insurance to reduce risk
Diversification
Reduce risk by investing in not highly correlated assets
Reduce unsystematic risk
Costless way to reduce risk
Hedging
Reduce risk by sacrificing upside gain
Future, forward and swap
Insurance
Reduce risk by paying a premium. Option is similar to insurance
The intrinsic value of an option is the difference between the exercise price and current price
Derivative securities
The value is based on underlying simple securities
The market is more efficient, liquid and used to hedge risk
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