Terms in this set (99)

On a graph, the difference btwn short-term and long-term interest rates

Upward sloping = normal/positive yield curve (means that long-term interest rates higher than short-term)

Long-term interest rates usually higher to compensate lenders for:
- time value of $;
- reduced buying pwr of $ resulting from inflation;
- increased risk of default over long periods; and
- loss of liquidity associated with long-term investments

Note: yield curve also reflects investor expectations about inflation; if expect high inflations then will require higher rates of interest to compensate for reduction in purchasing pwr over time

YIELD CURVE & ECONOMIC CYCLE

Normal/ascending yield curve
-occurs during periods of economic expansion.
-Predicts that interest rates will rise in the future

Flat yield curve occurs
-when the economy is peaking
-no change in interest rates is expected (short-term & long term rates the same)

Inverted/downward yield curve
- unusual
-occurs when FRB has tightened credit.
-Predicts rates will fall in future.
-result of high current demand for $ relative to supply.
-Short-term rates more sensitive to Fed policy than long-term. If sharp increase in short-term rates creates an inverted yield curve

Yield curves for issuers with different risk levels can be compared to make economic predictions
- if the yield curve spread btwn corp bonds and govt bonds is widening, then a recession is expected (investors choosing safety of govt bonds).
- If yield curve btwn corp and govt bonds is narrowing, then economic expansion expected (investors willing to take risks & sell govt bonds to buy higher yield corporates)

Most common method to construct yield curve: use bonds of a single issuer over varying maturities
3 broad categories of economic indicators of business cycle phases:
1. leading
2. coincident
3. lagging

Published on a monthly basis by The Conference Board (non-govt not-for-profit)

Leading indicators
-economic activities that tend to turn down before a recession or turn up before the beginning of an expansion
- used by economists to predict direction of economic activity 4-6 months hence
- not all leading indicators move in tandem, but positive changes in a majority point to increased spending, production & employment
- Include:
1. money supply
2. building permits
3. average weekly initial claims for unemployment insurance
4. average weekly hours in manufacturing
5. manufacturers' new orders for consumer goods
6. manufacturers' new orders for non defense capital goods
7. Index of supplier delivers- vendor performance
8. Interest rate spread btwn the 10-year Treasury bond and the federal funds rate
9. Stock prices
10. Index of consumer expectations

Coincident (current) indicators
- economic measurements that change directly and simultaneously with the business cycle
- Include:
1. nonagricultural employment
2. personal income (minus SS, vet benefits, & welfare)
3. Industrial production
4. Manufacturing and trade sales in constant dollars

Lagging indicatore
- measurements that change 4-6 months AFTER the economy has begun a new trend
-confirm trend; help analysts differentiate long-term trends from short-term reversals
- Include:
1. average duration of unemployment
2. ratio of consumer installment credit to personal income
3. ratio of manufacturing and trade inventories to sales
4. average prime rate
5. change in the CPI for services
6. total amount of commercial and industrial loans outstanding
7. change in the index of labor cost per unit of output (manufacturing)
Alpha = extent to which asset's or portfolio's actual return exceeds or falls short of its expected returns (want a positive alpha)

Arbitrage = strategy that generates a guaranteed profit from a transaction (e.g. - simultaneous purchase and sale of a security in different markets at different prices to lock in a profit)

Beta = a measure of a stock or portfolio's volatility in relation to the overall market
- Beta of 1 = moves in line with market
- Beta >1 = more volatile than overall market
- Beta < 1 = less volatile

Capital asset pricing model (CAPM) = securities market investment theory that attempts to service the expected return ion an asset on the basis of the asset's systematic risk

Completely diversified portfolio = specific risk in each asset has been diversified away

Earnings multiplier = another term for "price-to-earning (PE) ratio." Price of the stock divided by its earnings per share

Efficient market theory = belies that prices of securities rapidly reflect simultaneous access to all information

monte carlo simulation = statistical method to determine the return profile of a security/portfolio that recreates potential outcomes by generating random values on the basis of the risk and return characteristics of the securities themselves

optimal portfolio = provides highest expected returns for a given level of risk

risk-free rate = interest rate of 90 day T-bill

R-squared = statistical measure in the beta family. Used to reference what percentage of a portfolio's performance can be tied to a standard benchmark
- Range from 0-100
- If 100, then the security (or portfolio) moves right in line with the index
- when drops below 50%, the performance of the security (or portfolio) does not have much in common with the index
- higher R-squared value will indicate a more useful beta figure: if R-squared close to 100 but has beta below 1, most likely offering higher risk-adjusted returns. A low R-squared means you should ignore the beta

Sharpe ratio = measure of security or portfolio's risk in comparison to its expected return.
-Calculated as the portfolio's average return that is in excess of the risk-free rate dividend by the standard deviation of the portfolio
- higher the sharpe ratio, more attractive the investment

systematic risk= (a.k.a. "market risk"). Risk in the return of an investment that is associated with the macroeconomic factors that affect all risky assets.

unsystematic risk = specified with an investment (combined w/systematic risk, equal the total risk of an investment)
4 elements builds a corporations capital structure:
1. Long-term debt
2. Capital stock (common & preferred)
3. Capital in excess of par
4. Retained earnings (surplus)

If company changes its capitalization by issuing stocks or bonds, the effects will show up on the balance sheet

issuing securities
- When issue shares, the net worth on balance sheet increases by the additional capital raised ("liability/net worth" side)
- Cash on the "asset" side increases

convertible securities
- when investor converts bond into shares of common stock, the liabilities decreases and owner's equity increases.
- Note: changes are on the same side of the balance sheet, no change to assets

bond redemption
- liabilities reduced
- decrease in cash on the asset side of the balance sheet
- Note: bc the current asset (cash) was used to redeem a long-term liability (bond), working capital is reduced. But, bc no longer have semi-annual interest payments on the bond, the future effect is to increase company's cash flow

dividends
A. Cash
- Declared: retained earnings are lowered and current liabilities increase
- Paid: cash lowered and current liabilities increase
B. Stock
- no change (# of shares each shareholder owns increases, but each single share represents a smaller slice of ownership in the company, so its a wash)

stock splits
- does not affect shareholder's equity
- on balance sheet, only par value per share and # of shares outstanding change

financial leverage
-A company's ability to use long-term debt to increase its return on equity
- stockholders benefit from leverage if the return on borrowed money exceeds the debt service costs. But risky bc increases risk of default & company affected more by changes in interest rates
- A company with a high ratio of long-term debt to equity is "highly leveraged":
A. industrial companies = debt-to-equity ratio of 50%+ considered highly leveraged
B. utility companies = bc of relatively stable earnings & cash flow, can be highly leveraged without undue risk
- DEBT-TO-EQUITY ratio = Long-term debt/ capitalization

book value per share
- fundamental analyst focuses on the company's books
- book value per share similar to NAV per share of an investment company.
- for corp, it is the liquidation value of the enterprise
- Do not include intangible assets (i.e., goodwill)
-Formula: (tangible assets-liabilities- par value of preferred) ÷ (shares of common stock outstanding) = book value per share
- risks that can be reduced thru diversification
- unique to specific industry or business enterprise, such as labor union strikes, lawsuits, product failure
- primary types: business, financial, liquidity, political, regulatory

Business risk
- An operating risk; generally caused by poor management decisions
- higher for investors whose portfolios contain stock in only 1 issuer or in lower rated bonds

Financial risk
- relates primarily to companies using debt financing (leverage). This is the inability to meet those debt obligations, which could lead to bankruptcy

Regulatory risk
- Individual companies and industries are affected by changes in rules
- investments that could be affected include "green industries" (and those that tend to pollute), oil and gas exploration, airlines, & pharmaceutical manufacturers
- the most common regulatory risk comes from govt agency attempts to control product prices or the competitive structure of a particular industry thru the passage and enforcement of regulations

Political risk
- different from regulatory & legislative risk
- political instability

Sovereign risk
- risk of a country defaulting on its commercial debt obligations

Country risk
- evaluates total investment risk of a country, such as risk of default on a bond, risk of losing direct investment, risk to global business dealings, by both qualitative and quantitative factors
- qualitative: political risk, economic performance, structural assessment
- quantitative: debt indicators, credit ratings, access to bank finance

Liquidity risk
- risk that when an investor wishes to dispose of an investment, no one wants to buy it or not possible at the current price
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