Terms in this set (248)
Fixed-income (debt securities)
are a fixed stream of income or a stream of income determined by a specified formula.
Equity (common stock)
represents an ownership share in the corporation
Derivative Securities (options and futures)
provide payoffs that are determined by the prices of other assets such as bond or stock prices.
managers, who are hired as agents of the shareholders, may pursue their own interests instead.
when shareholders seek to obtain enough proxies (i.e. rights to vote the shares of other shareholders) to take control of the firm and vote in another board of directors.
the choice of what types of asset classes to invest in
the choice of what types of securities to hold within each asset class
involves the valuation of particular securities that might be included in the portfolio
Higher-risk assets priced to offer higher expected returns than lower-risk assets
calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis.
is the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes.
issue their own securities to raise funds to purchase the securities of other corporations. Ex: banks, investment companies, insurance companies, and credit unions.
pool and mange the money of many investors.
advise the issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth. (Ultimately the investment banking firm handles the marketing of the security in the primary market)
Collateralized debt obligations (CDOs)
were designed to concentrate the credit (i.e., default) risk of a bundle of loans on one class of investors, leaving the other investors in the pool relatively protected from that risk. The idea was to prioritize claims on loan repayments by dividing the pool into senior vs junior slices, called tranches
Credit default swaps (CDS)
is in essence an insurance contract against the default of one or more borrowers. The purchaser of the swap pays an annual premium (like an insurance premium) for protection from credit risk. (selling too many of these f**ked AIG up)
is a potential breakdown of the financial system when problems in one market spill over and disrupt others.
The Money Market
is a subsector of the fixed-income market. It consists of very short term debt securities that usually are highly marketable.
U.S. Treasury Bills (T-bills)
are the most marketable of all money market instruments. They represent the simplest form of borrowing: the government raises money by selling these to investors. They are issued with initial maturities of 4, 13, 26, or 52 weeks. They sell in minimum denominations of only $100. Income is exempt from all state and local taxes.
Certificates of deposit (CD)
is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD.
is when large, well known companies issue their own short-term unsecured debt notes rather than borrow directly from banks. Usually with maturities less than 1 or 2 months.
starts as an order to a bank by a bank's customer to pay a sum of money at a future date, typically within 6 months.
are dollar-denominated deposits at foreign banks or foreign branches of American banks
Repurchase agreements (repos or RPs)
serve as a form of short-term, usually overnight, borrowing.
are funds in the bank's reserve account (at the Federal Reserve Bank)
London Interbank Offered Rate (LIBOR)
is the rate at which large banks in London are willing to lend money among themselves. It serves as a reference rate for a wide range of transactions
Money market funds
are mutual funds that invest in short-term debt instruments that comprise the money market.
Yield to maturity
is quoted on an annual percentage rate (APR) basis rather than as an effective annual yield. It is the rate of return anticipated on a bond if it is held until the maturity date.
Eurobond (or simply 'international bonds')
is a bond denominated in a currency other than that of the country in which it is issued.
are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation. The interest also is exempt from state and local taxation in the issuing state. (usually have lower yields because of the tax exemption)
Equivalent taxable yield
is the rate a taxable bond must offer to match the after-tax yield on the tax-free municipal. r(1-t) = r_m
are the means by which private firms borrow money directly from the public. (higher default risk than Treasury bonds)
Mortgage-backed security (also called pass-throughs)
is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. These claims represent securitization of mortgage loans. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. Specifically, they sell their claim to the cash inflows from the mortgages as those loans are paid off. The mortgage originator continues to service the loan, collecting principal and interest payments, and passes these payments along to the purchaser of the mortgage.
are riskier loans made to financially weaker borrowers.
means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation.
means that the most shareholders can lose in the event of failure of the corporation is their original investment.
i.e. price increases or loses
Price-earnings ratio (P/E ratio)
is the ratio of the current stock price to last year's earnings per share. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings that the firm generates.
has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year. It is similar to an infinite-maturity bond, that is, a perpetuity.NO VOTING POWER. Preferred dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock.
American Depository Receipts (ADRs)
are certificates traded in U.S. markets that represent ownership in shares of a foreign company. Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares of the foreign corporation ADRs were created to make it easier for foreign firms to satisfy U.S. security registration requirements.
Dow Jones Industrial Average (DJIA)
is the average of 30 large, "blue-chip" corporations. It is calculate using a price-weighted average.
Standard & Poor Composite 500 (S&P 500)
represents an improvement over the Dow Jones Averages in two ways. First, it is a more broadly based index of 500 firms. Second, it is a market-value-weighted index.
Weight is determined by total market value (stock outstanding)
are shares in mutual funds that hold shares in proportion to their representation in the S&P 500 or another index. They yield a return equal to that of the index and so provide a low-cost passive investment strategy for equity investors.
Wilshire 5000 index
is an the index of the market value of essentially all actively traded stocks in the U.S. despite its name, the index actually holds 6000 stocks
Equally Weighted Indexes
places equal weight on each return.
International Stock Market Indexes
Nikkei (Japan), FTSE (U.K.; pronounced "footsie"), DAX (Germany), Hang Seng (Hong Kong), and TSX (Canada).
futures, options, and related derivative markets
gives the holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date. Each option contract is for the purchase of 100 shares.
gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date.
calls for delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity. You have an OBLIGATION; and a premium is not required.
Initial Public Offerings (IPOs)
stocks issued by a formerly privately owned company that is going public, that is, selling stock to the public for the first time
Seasoned equity offerings
are for companies who have already floated equity and wish to issue new shares
statement printed in red that states that the company is not attempting to sell security before the registration is approved (this is to the SEC)
when a firm (using an investment banker) sells shares directly to a small group of institutional or wealthy investors
Direct search market
is the least organized market. Buyers and sellers must seek each other out directly.
is a market where trading is active, brokers find it profitable to offer search services to buyers and sellers. (ex: primary market)
is the most integrated market, in which traders converge at one place to buy or sell an asset. (Ex: NYSE)
are buy or sell orders that are to be executed immediately at current market prices. Sometimes the posted price quote only represents commitments to trade up to a specified number of shares. Also, another trader might beat your broker to the quote so the price might change.
Limit buy order
may instruct the broker to buy some shares if a certain stock is at or below a stipulated price
Limit sell order
may instruct the broker to sell some shares if a certain stock rises above a certain price (limit)
are similar to limit orders in that the trade is not to be executed unless the stock hits a price limit. For stop-loss orders, the stock is to be sold if its price falls below a stipulated level (to stop further loses). Stop-buy orders specify that a stock should be bought when its price rises above a limit (often accompany short sales, i.e. used to limit potential losses).
Over-the-counter market (OTC)
Thousands of brokers register with the SEC as security dealers. Dealers quote prices at which they are willing to buy or sell securities. A broker then executes a trade by contacting a dealer listing an attractive quote
Electronic communication networks
allow participants to post market and limit orders over computer networks.
large transactions exceeding 10,000 shares. (Too large for specialists to handle). These large transactions are usually taken care of by "block houses," which are brokerage firms that specialize in block trading
is a coordinated purchase or sale of an entire portfolio of stocks
are financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or other assets. Pooling of assets is the key idea behind investment companies.
Net asset value (NAV)
Investors buy shares in investment companies, and ownership is proportional to the number of shares purchased. The value of each share is called the net asset value (NAV). NAV equals assets minus liabilities expressed on a per-share basis: NAV = (Market value of assets minus liabilities)/ Shares outstanding.
Unit investment trusts
are pools of money invested in a portfolio that is fixed for the life of the fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a portfolio of securities that are deposited into a trust. It then sells shares, or "units," in the trust, called redeemable trust certificates. All income and payments of principal from the portfolio are paid out by the fund's trustees (a bank or trust company) to the shareholders. The management is passive.
Managed Investment companies
like unit investment trusts except the investment portfolios are continually bought and sold.There are two types: open-end funds, and closed-end funds.
stand ready to redeem or issue shares at their net asset value. When investors in open-end funds wish to "cash out" their shares they sell them back to the fund at NAV.
in contrast to open-end funds, closed-end funds do not redeem or issue shares. Investors in closed-end funds who wish to cash out must sell their shares to other investors. Shares of closed-end funds are traded on organized exchanges and can be purchased through brokers just like other common stock; their prices, therefore, can differ from NAV.
is a sales charge.
are partnerships of investors that pool funds. The management firm that organizes the partnership for example, a bank or insurance company, manages the funds for a fee. Typical partners in a commingled fund might be trust or retirement accounts with portfolios much larger than those of most individual investors, but still too small to warrant managing on a separate basis. They are similar in form to open-end mutual funds.
Real Estate Investment Trusts (REITs)
a REIT is similar to closed-end funds. They invest in real estate or loans secured by real estate. Besides issuing shares, they raise capital by borrowing from banks and issuing bonds or mortgages. Most are highly leveraged. There are two kinds: Equity trusts, and Mortgage trusts.
is an REIT that invests in real estate directly
is an REIT that invests primarily in mortgage and construction loans.
are vehicles that allow private investors to pool assets to be invested by a fund manager. Unlike mutual funds, they are commonly structured as private partnerships and thus subject to only minimal SEC regulation. Since they are lightly regulated, their managers pursue investment strategies involving heavy use of derivatives, short sales, and leverage; these are things that mutual funds don't do.
invest primarily in stock. Usually they'll keep between 4 and 5% in money market securities to provide liquidity necessary to meet potential redemption of shares.
tend to hold shares of firms with consistently high dividend yields.
are willing to forgo current income, focusing instead on prospects for capital gains, in practice, the more relevant distinction concerns the level of risk these funds assume. (growth funds are riskier than income funds)
concentrate on a particular industry.
specialize in fixed-income securities
are "high-yield" bonds with a lot of risk.
invest in securities of firms located outside the United States.
hold both equities and fixed-income securities in relatively stable proportions.
Asset Allocation and Flexible Funds
these funds are similar to balanced funds b/c they hold stocks and bonds. However, these funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager's forecast of the relative performance of each sector.
tries to match the performance of a broad market index.
is a conflict of interest when funds companies pay the brokerage firm for preferential treatment when making investment recommendations.
is a commission or sales charge paid when you purchase the shares. These charges are primarily used to pay the brokers who sell the funds.
is a redemption, or "exit," fee incurred when you sell your shares.
A portfolio manager earns soft-dollar credits with a brokerage firm by directing the fund's trades to that broker. on the basis of those credits, the broker will pay for some of the mutual fund's expenses, such as databases, computer hardware, or stock-quotation systems
Exchange-traded funds (ETFs)
are offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock.
Nominal interest rate
the growth rate of your money,
Real interest reate
the growth rate of your purchasing power,
R = nominal rate, r= the real rate, i = the inflation rate; now organize them in an equation
r = R - i, approximately
What three basic factors determine the real interest rate?
supply, demand, government actions.
What other fourth factor affects the interest rate?
the expected rate of inflation
Risk-free Return for zero coupon bond
Par value/Price - 1
HPR = (Ending price of a share - Beginning price + Cash dividend)/Beginning price. This doesn't take into account reinvestment income.
The difference between the HPR and the Risk-Free Rate. (Risk premium is also considered the expected value of the excess return)
The difference in any particular period between the actual rate of return on a risky asset and the actual risk-free rate.
Risk averse investors reject what kind of portfolios?
Portfolios that are fair games or worse. (They always look for a risk premium)
is what an investor assigns to a competing portfolio on the basis of the expected return and risk of those portfolios.
Certainty Equivalent Rate
is the rate that risk-free investments would need to offer to provide the same utility score as the risky portfolio.
judge risky prospects solely by their expected rates of return. The level of risk is irrelevant to the risk-neutral investor, meaning that there is no penalty for risk. For this investor a portfolio's certainty equivalent rate is simply its expected rate of return.
adjust the expected return upward to take into account the "fun" of confronting the prospect's risk.
Money market funds hold, for the most part, what three types of securities?
Treasury bills, bank certificates of deposit (CDs), and commercial paper (CP)
Capital allocation line (CAL)
depicts all the risk-return combinations available to investors.All combinations of the risky asset and the risk-free asset lie on this line. The slope equals the increase in the expected return of the complete portfolio per unit of additional standard deviation--in other words, incremental return per incremental risk. Other things equal, an investor would prefer a steeper-sloping CAL, because that means higher expected return for any level of risk. If the borrowing rate is greater than the lending rate, the CAL will be "kinked" at the point of the risky asset.
Reward-to-volatility ratio (Sharpe ratio)
is the slope of the CAL. It equals the increase in the expected return of the complete portfolio per unit of additional standard deviation--in other words, incremental return per incremental risk. S = (Expected return on portfolio - risk-free rate)/ standard deviation of portfolio
is the undertaking of a risky investment for its risk premium. The risk premium has to be large enough to compensate a risk-averse investor for the risk of the investment.
shows at any level of expected return and risk, the required risk premium for taking on one additional percentage point of standard deviation. More risk-averse investors have steeper indifference curves; that is, they require a greater risk premium for taking on more risk. The investor's degree of risk aversion is characterized by the slope of his or her indifference curve.
when we construct risky portfolios to provide the lowest possible risk for any given level of expected return
The lower the correlation between the assets...
the greater the gain in efficiency.
Portfolio opportunity set
shows all combinations of portfolio expected return and standard deviation that can be constructed from the two available assets.
Market portfolio (M)
includes all traded assets. For simplicity, we generally refer to all risky assets as stocks. The proportion of each stock in the market portfolio equals the market value of the stock divided by the total market value of all stocks. The market portfolio is on the efficient frontier and it is tangent to the optimal capital allocation line (CAL) derived by every investor. The risk premium on (M) is proportional to its risk and degree of risk aversion
graph representing a set of portfolios that maximize expected return at each level of portfolio risk.
measures the extent to which returns on the stock and the market move together. B = Cov(r_i, R_m)/Variance of the market portfolio
CAPM implies that...
...as individuals attempt to optimize their personal portfolios, they each arrive at the same portfolio, with weights on each asset equal to those of the market portfolio.
Mutual Fund Theorem
is a passive strategy of investing in a market index portfolio that is efficient. The practical significance is that a passive investor may view the market index as a reasonable first approximation to an efficient risky portfolio.
Reward-to-risk ratio (for the market portfolio) (often called the market price of risk)
Market risk premium/Market variance. E(r_m) - r_f/ Variance of
Reward-to-risk ratio (for an individual security)
Risk premium/Covariance of security and market
Differences between the Capital Market Line (CML) and the Security Market Line (SML):
The CML graphs the risk premiums of efficient portfolios (i.e., portfolios composed of the market and the risk-free asset) as a function of portfolio standard deviation. The SML, in contrast, graphs individual asset risk premiums as a function of asset risk. The relevant measure of risk for individual assets held as parts of well-diversified portfolios is not the asset's standard deviation or variance; it is instead the contribution of the asset to the portfolio variance, which we measure by the asset's beta. The SML is valid for both efficient portfolios and individual assets.
What does it mean when a stock provides an expected return in excess of the fair return stipulated by the SML?
it is perceived to be a good buy or underpriced. Underpriced stocks therefore plot above the SML: Given their betas , their expected returns are greater than dictated by the CAPM. Overpriced stocks plot below the SML.
The Arbitrage Price Theory (APT) relies on what three key propositions?
1) security returns can be described by a factor model; 2) there are sufficient securities to diversify away idiosyncratic risk; and 3) well-functioning security markets do not allow for the persistence of arbitrage opportunities.
arises when an investor can earn riskless profits without making a net investment.
Law of one price
if two assets are equivalent in all economically relevant respects, then they should have the same market price.
The most fundamental concept in capital market theory is:
the idea that market prices will move to rule out arbitrage opportunities.
A field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.
means that investors are too slow (too conservative) in updating their beliefs in response to new evidence. This means they might initially underreact to news about a firm, so that prices will fully reflect new information only gradually. Such a bias would give rise to momentum in stock market returns.
holds that people commonly do not take into account the size of a sample, acting as if a small sample is just as representative of a population as a large one.
individuals may act risk averse in terms of gains bust risk seeking in terms of losses.
is a specific form of framing in which people segregate certain decisions. The importance of this theory is illustrated in its application towards the economic behavior of individuals, and thus entire populations and markets. Rather than rationally viewing every dollar as identical, mental accounting helps explain why many investors designate some of their dollars as "safety" capital which they invest in low-risk investments, while at the same time treating their "risk capital" quite differently
Utility depends not on the level of wealth, but on...
...changes in wealth from current levels.
"markets can remain irrational longer than you can remain solvent." i.e. the price of a stock may not converge to its intrinsic value for a long time.
attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance.
refers to the tendency of investors to hold on to losing investments.
Dow Theory posits what three forces that simultaneously affecting stock price:
1.) The primary trend is the long-term movement of prices, lasting from several months to several years. 2.) Secondary or intermediate trends are caused by short-term deviations of prices from the underlying trend line. These deviations are eliminated via corrections when prices revert back to trend values. 3.) Tertiary or minor trends are daily fluctuations of little importance.
is the ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds. The ratio will always be below 100% because higher rated bonds will offer lower promised yields to maturity. Higher values of the confidence index are bullish signals.
annual coupon divided by current price
is the contract between the issuer and the bondholder. It includes the coupon rate, maturity date, and par value of the bond.
stated price plus the accrued interest
if a company issues a bond with a high coupon rate when market interest rates are high and interest rates later fall, the firm might like to retire the high-coupon debt and issue new bonds at a lower coupon rate to reduce interest payments. (in reference to callable bonds)
give bondholders an option to exchange each bond for a specified number of shares of common stock of the firm.
is the number of shares for which each bond may be exchanged
gives the issuer the option to buy back the bond
Putable bond (or extendable bond)
give the bondholder the option of selling the bond back.
are bonds that are denominated in the currency of the country in which it is marketed. The issuer is from a country other than the one in which the bond is sold.
are denominated in one currency usually that of the issuer, but sold in other national markets.
Inverse floater bonds
similar to floating-rate bonds except that the coupon rate on these bonds falls when the general level of interest rates rises.
Example: Walt Disney has issued bonds with coupon rates tied to financial performance of several of its films. More conventional asset-backed securities are mortgage-backed securities or securities backed by auto or credit card loans.
are bonds selling above par value, coupon rate is greater than current yield, which in turn is greater than yield to maturity.
are bonds selling below par value, coupon rate is below yield to maturity
forecasting the realized compound yield over various holding periods or investment horizons
Bond stripping and bond reconstruction
is either stripping a bond that is selling less than the sum of its parts could be sold, and then selling it, or if a bond is priced higher than a bunch of zero coupon bonds, you buy the separate bonds and construct a bond and profit from the difference.
Pure yield curve
refers to the curve for stripped, or zero-coupon, Treasuries.
On-the-run yield curve
refers to the plot of yield as a function of maturity for recently issued coupon bonds selling at or near par value. This is the one in he financial press.
is the interest rate for a given time interval available at different points in time
The yield or spot rate on a long-term bond reflects the path or short rates anticipated by the market over the life of the bond.
The interest rate that actually will prevail in the future need not equal the forward rate, which is calculated from today's data. Indeed, it is not even necessarily the case that the forward rate equals the expected value of the future short interest rate. However, not that forward rates equal future short rates in the special case of interest rate certainty.
is the yield to maturity on zero-coupon bonds
compensates short-term investors for the uncertainty about the price at which they will be able to sell their long-term bonds at the end of the year. (Basically they are compensated for having their money tied up) It is the excess of f_2 over E(r_2)
is that the forward rate equals the market consensus expectation of the future short interest rate.
Liquidity preference theory of the term structure
advocates of this believe that short-term investors dominate the market so that the forward rate will generally exceed the expected short rate.
The yield curve is upward-sloping when
at any maturity date, n, for which the forward rate for the coming period is greater than the yield at that maturity.
is the break-even future interest rate that would equate the total return from a rollover strategy to that of a longer-term zero-coupon bond. f_n = E(r_n) + Liquidity premium
the spread between yields on long and short term bonds, generally are positive, then a downward-sloping yield curve might signal anticipated declines in rates, possibly associated with an impending recession.
An expected change in interest rates can be due to changes in either:
expected real rates or expected inflation rates.
High real rates may indicate what?
a rapidly expanding economy, high government budget deficits, and tight monetary policy.
High inflation rates can arise out of what?
a rapidly expanding economy, inflation also may be caused by rapid expansion of the money supply or supply-side shocks to the economy such as interruptions in oil supplies.
Between long-term and short-term bonds, which are more sensitive to interest rate changes?
Between high and low coupon rate bonds, which are more sensitive to interest rate changes?
Low coupon bonds. (Because more emphasis is placed on that last payment, i.e. face value)
What do you need to know to measure interest rate sensitivity?
The maturity, yield, and coupon rate.
How is the sensitivity of a bond's price to a change in its yield related to the yield to maturity at which the bond currently is selling?
It is inversely related.
What does Duration allow us to do?
It allows us to quantify the interest rate sensitivity which can greatly enhance our ability to formulate investment strategies.
The rules for Duration are:
1.) The duration of a zero-coupon bond is equal t its time to maturity; and a coupon bond with an equal maturity has a lower duration because coupons early in the bond's life lower the bond's weighted average time until payments.
2.) Holding maturity constant, a bond's duration is lower when the coupon rate is higher. In other words, a higher fraction of the total value of the bond is tied up in the (earlier) coupon payments whose values are relatively insensitive to yields rather than the (later and more yield-sensitive) repayment of par value.
3.) For virtually all traded bonds it is safe to assume that duration increases with its time to maturity (with the exception of deep-discount bonds)
When is convexity more accurate than duration?
When potential interest rate changes are large.
Why is convexity generally considered a desirable trait?
Because bonds with greater curvature gain more in price when yields fall than they lose when yields rise. (Picture the graph)
what is the Intrinsic value of an option?
It gives the payoff that could be obtained by immediate exercise.
What is the time value of an option?
It is the difference between the actual call price and the intrinsic value.
The volatility lies in...
..the value of the right NOT to exercise the call if that action would be unprofitable.
What are the six factors that affect the value of a call option?
The stock price, the exercise price, the volatility of the stock price, the time to expiration, the interest rate, and the dividend rate of the stock.
Will it ever pay to exercise an American call option early? (Assuming that it's on a non-dividend paying stock)
NO, because you can sell the option at or equal to a greater price than immediate exercise.
Will it ever pay off to exercise an American put option early?
YES, e.g. the firm goes bankrupt and the stock price will fall to zero. Exercise today :P
What is the Hedge Ratio? (H)
the ratio of the swings in the possible end-of-period values of the option and the stock. If the investor writes one option and holds H shares of stock, the value of the portfolio will be unaffected by the stock price.
What is dynamic hedging?
it is the continued updating of the hedge ratio as time passes.
What is the purpose of fundamental analysis?
it is to identify stocks that are mispriced relative to some measure of "true" value that can be derived from observable financial data.
What is book value?
It is the net worth of a company as reported on its balance sheet. The book value of an asset equals the ORIGINAL cost of acquisition less some adjustment for depreciation, even if the market price of that asset has changed over time
What is market value of the shareholders' equity investment?
It equals the difference between the current values of all assets and liabilities and liabilities.(The stock price is just the market value of shareholders' equity divided by the number of outstanding shares.)
What is a good measure for the "floor" of a stock price?
The firm's Liquidation value per share, which represents the amount of money that could be realized by breaking up the firm, selling its assets, repaying its debt, and distributing the remainder to the shareholders. The firm is usually an attractive takeover target if the market price of equity drops below liquidation value.
What is the expected holding-period return on a stock?
is the the expected dividend plus capital gain (based on expected stock price in the future) all divided by the current price.
What does the CAPM provide?
An estimate of the rate of return an investor can expect to earn on a security given its risk as measured by beta. The CAPM states that when stock market prices are at equilibrium levels, the rate of return that investors can expect to earn on a security is (Insert CAPM formula here). And it is often referred to as the "fair" or "required" return .
If a stock will provide an expected return greater than the required return then the stock is overpriced or underpriced? What should you do?
BUY BUY BUY
What is the intrinsic value of a stock?
it is the present value of all cash payments to the investor in the stock, including dividends as well as the proceeds from the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate.
If the intrinsic value, or the investor's own estimate of what the stock is really worth, exceeds the market price, is the stock considered under or over valued?
It is undervalued and a good investment.
What is the market capitalization rate?
It is the market-consensus estimate of the appropriate discount rate for a firms cash flows.
What is the Dividend Discount Model (DDM)?
It is the present value of all expected future dividends into perpetuity.
The constant-growth rate DDM implies that a stock's value will be greater:
1) The larger its expected dividend per share.
2) The lower the market capitalization rate, k.
3) The higher the expected growth rate of dividends
What is the dividend payout ratio?
The fraction of earnings paid out as dividends.
What is the plowback ratio?
The fraction of earnings reinvested in the firm. Also known as the earnings retention ratio.
A low-reinvestment-rate plan allows the firm to pay higher initial dividends, but what affect does it have the growth rate of dividends?
It results in a lower dividend growth rate. Eventually, a high-reinvestment-rate plan will provide higher dividends.
It a company pays out all earnings as dividends then how much is the firm growing?
It is pursuing a no-growth policy.
What is the present value of growth opportunities (PVGO)?
It is the net present value of a firms future investments.
What must a firm do to justify reinvestment?
It must engage in projects with better prospective returns than those shareholders can find elsewhere.
What is a "cash cow"?
It is a firm with considerable cash flow but limited investment prospects, i.e. a steady profit
What is the price-earnings multiple? And what does it indicate?
It is the ratio of price per share to earnings per share. It indicates expectations of growth opportunities.
What does a high P/E multiple indicate?
It indicates that a firm enjoys ample growth opportunities. That is, an investor might well pay a higher price per dollar of current earnings if he or she expects that earnings stream to grow more rapidly.
What does the P/E ratio do when ROE increases?
It also increases. This makes sense, because high ROE projects give the firm good opportunities for growth. Also, you can see it with the alternative way to express P/E: 1-b/k-ROExb.
When a firm has good investment opportunities, and the firm exploits those opportunities more aggressively by plowing back more earnings into those opportunities, what will the P/E ratio do?
The market will reward the firm with a higher P/E ratio.
A higher plowback rate does not necessarily mean a higher P/E ratio because; why is that?
Higher plowback increases P/E only if investments undertaken by the firm offer an expected rate of return greater than the market capitalization rate. Otherwise, increasing plowback hurts investors because more money is sunk into projects with inadequate rates of return.
What is the PEG ratio?
It is the ratio of P/E to g. Peter Lynch said that it should be equal to 1.0. A common wall street rule of thumb is that the growth rate ought to be roughly equal to the P/E ratio. If the P/E ratio is less than the growth rate, you may have found yourself a bargain.
Holding all else equal, what kind of P/E multiples will riskier stocks have?
They will have lower P/E mulitples. We can see that in the formula for the P/E ratio: 1-b/k-g. Riskier firms will have higher required rates of return, that is, higher values of k. Therefore the P/E multiple will be lower. (This is also true for constant-growth models). Also, small, risky, start-up companies sometimes might have very high P/E multiples because the market's expectations predict high growth rates for those companies (It is not a contradiction)
When inflation rises, what do P/E ratios do?
They fall. This is because the replacement cost of both goods and capital equipment will rise with general level of prices.
What is earnings management?
It is the practice of using flexibility in accounting rules to improve the apparent profitability of the firm.
How does the "normal" P/E ratio differ from the P/E ratio in the financial pages of the newspaper?
The "normal" P/E ratio is the ratio of today's price to the trend value of future earnings while the one in the financial pages is the ratio of price to the most recent PAST accounting earnings.
What is the Price-to-book ratio?
The ratio of price per share divided by book value per share. Some analysts view book value as a useful measure of value.
What is the Price-to-cash-flow ratio?
It is the ratio of price to cash flow per share rather than earnings per share. Many analysts like this ratio because it uses the cash actually flowing into or out of the firm and is less affected by accounting decisions.
What is the price-to-sales ratio?
It is the ratio of price to annual sales per share. It is used to evaluate start-up firms because they have no earnings.
What is the free cash flow to the firm? (FCFF)
It is the after-tax cash flow that accrues from the firm's operations, net investments in capital and net working capital. It includes both debt-and equityholders. FCFF = EBIT(1-t_c) + Depreciation - Capital expenditures - Increase in NWC (net working capital)
What is free cash flow to equityholders? (FCFE)
It differs from FCFF by after-tax interest expenditures, as well as by cash flow associated with net issuance or repurchase of debt (i.e. repayments minus proceeds from issuance of new debt). FCFE = FCFF - Interest expense(1-t_c) + Increases in net debt
What is the weighted average cost of capital?
It is the weighted average of the after-tax cost of debt and the cost of equity in each year.
What is the net profit of a call option?
The value of the option minus the price originally paid to purchase it. (The value of the option is the difference between the exercise price and the stock price)
What advantage does an option traded on an over-the-counter market have?
The terms of the option contract--the exercise price, expiration date, and number of shares committed--can be tailored to the needs of the traders. The costs of establishing an OTC option contract, however, are higher than for exchange-traded options.
How do options traded on exchanges differ from options traded on over-the-counter markets?
The options contracts traded on exchanges are standardized by allowable expiration dates and exercise prices for each listed option. Each option contract provides for the right to buy or sell 100 shares of stock. Also, standardization of the terms of listed option contracts means all market participants trade in a limited and uniform set of securities. This increases the depth of trading in any particular option,which lower trading costs and results in a more competitive market. Exchanges, therefore, offer two important benefits: ease of trading, and a liquid secondary market.
What does "open interest" mean in terms of option trading?
It means the number of outstanding contracts
What are LEAPS?
LEAPS: Long-Term Equity AnticiPations Securities. They are basically longer-term options for larger firms and several stock indexes.
Virtually all traded options in the United States are of what style? (American or European)
They are American.
Options adjust for stock splits.
What is an index option?
It is a call or put based on a stock market index such as the S&P 500 or the NASDAQ 100.
What do Futures Options give their holders the right to do?
They give them the right to buy or sell a specified futures contract, using as a futures price the exercise price of the option.
What is the difference between a currency option and a currency futures option?
A currency option offers the right to buy or sell a quantity of foreign currency for a specified amount of domestic currency. The important difference is that the former provides payoffs that depend on the difference between the exercise price and the exchange rate at maturity. The latter are foreign exchange futures options that provide payoffs that depend on the difference between the exercise price and the exchange rate futures price at maturity.
What is a naked put?
Writing a put without an offsetting short position in the stock for hedging purposes.
When considering writing and purchasing calls and puts, which are the bearish and which are the bullish strategies?
Buying calls and writing puts are bullish. (The other two are bearish)
What is a protective put?
Buying the stock and also buying a put option as insurance.
What is a covered call?
It is the purchase of a stock with a simultaneous sale of a call on that stock.
What is naked option writing?
Writing an option without an offsetting stock position.
What is a long straddle? (And what is a written straddle)
A long straddle is the purchase of a call and put at the same strike and expiration. It is basically a bet on large volatility. The downside is it is expensive. A written straddle is the opposite (it is a bet on very little volatility.
What are "strips" and "straps"?
They are both variations of straddles. A strip is two puts and one call; while a strap is two calls and one put.
What is a spread?
A spread is a combination of two or more call options (or two or more puts) on the same stock with differing exercise prices of times to maturity. Some are bought, whereas others are sold, or written.
What is a money spread?
It involves the purchase of one option and the simultaneous sale of another with a different exercise price.
What is a time spread?
It refers to the sale and purchase of options with differing expiration dates.
What is a collar?
It is an options strategy that brackets the value of a portfolio between two bounds.
What is the Put-Call Parity relationship?
That a purchased call with a bond that has the maturity value of the strike price should equal the price of a protected put (long on stock and long put)
What is the difference in price of a callable bond and a straight bond with the same coupon rate?
The difference in the price equals the price of a call option.
What is a convertible bonds conversion value?
It equals the value it would have if you converted it into stock
What is the "bond floor" of a convertible bond?
It is the value the bond would have if it were not convertible into stock.
What is the "implied volatility"?
It is the standard deviation of stock returns that is consistent with an option's market value.
What affect do periods of turmoil have on implied volatility?
It causes it too spike quickly.