finance final
Terms
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- value of a financial investment
- equals the present value of its expected future cash flows, discounted for the risk and timing of those cash flows
- discount
- multiply a number by less than one
- discount rate
- a function of time and risk; discount rate=f(time,risk)
- discount factor
- a function of both time and the discount rate [discount factor=f(time, discount rate)]
- present value
- sum of the expected cash flows multiplied by their respective discount factors
- three-step approach to dcf valuation
-
1. develop a set of expected cash flows
2.estimate the discount rate and calculate the discount factors
3. multiply the cash flows by the discount factors and add them to determine the value of an asset - decision rule
-
if value is greater than price-buy
if value if less than price-sell - project
- investment to produce a product or provide a service that will generate money in the future
- cash inflows/outflows
- additional revenues/expenses coming into/being spent by the company as a result of the project
- bond
- debt instrument, corporations, us govt. and municipalities issue bonds
- stock
- represents ownership interest in a corporation
- capital budgeting
- process of planning and managing a firm's long-term investment in projects and ventures
- net present value
- difference between the value of an investment and its cost
- npv rule
- invest in projects if the npv of the project is positive and do not invest in projects if the npv is negative
- internal rate of return
- rate of return that is expected to be earned on a project, discounting rate tha tmakes the npv of an investment equal to zero
- irr rule
- if the investment has an irr that is higher than some predetermined required rate of return, accept the investment and vice versa
- payback period
- length of time for the return on an investment to cover the cost of the investment
- payback rule
- accept the investment if its payback period is less than a predetermined number of years and reject the investment if its payback period is greater than the predetermined number of years
- capital asset pricing model
- estimates the rate of return an investor should expect to receive on a risky asset, purpose is to determine the discount rate to use when valuing an asset
- risk premium
- function of the stock's beta and the market risk premium (exp. return on overall stock market - risk free rate)
- beta
- risk, market-related/systematic, slope of stock return to market return
- alpha
- observed return of asset-expected return of asset
- unsystematic risk
- risk that can be diversified away
- systematic risk
- market related risk as measured by beta, cannot be diversified away
- efficient market
- market where all investments are accurately priced
- random walk hypothesis
- share prices react immediately to news so that there is no predictable trend implied by a more gradual share price adjustment, also the next news event leading to the next immediate adjustment cannot be predicted, in efficient market, share price changes are random
- fama and french study
- compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics, called to question the validity of efficient capital markets
- fixed rate par bond
- 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
- 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
- prepayment risk
- 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
- spread to treasuries
- difference between the yield on a noncallable us t-bond and the yield on a noncallable corporate bond with an identical maturity
- municipal bonds
- debt instruments issued by states, cities, municipal authorities and other entities, interest income is exempt from federal tax
- yield curve
- describes the relationship between the yield on a security and its maturity
- technical analysis
- stock prices influenced more by investor psychology and emotions of the crowd, chart historic stock price movements, volume of trading activity, shorter-term stock holding orientation, more frequent trading activity
- fundamental analysis
- company's current and future operating and financial performance determine the value of the company's stock, underlying assumption is that a company's stock has a true or intrinsic value to which its price is anchored, evaluate overall economic, industry and company date to estimate a stock's value
- modern portfolio theory
- efficient capital markets is cornerstone of mpt-belief that stock prices always reflect intrinsic value, tells 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
- ways to reduce risk associated with financial assets
- diversification, hedging, insurance, sell the assets
- insurance
- pay a premium to protect against loss
- strike price
- also known as exercise price, predetermined
- expiration date
- after which the option can no longer be exercised
- put option
- enables the owner to sell an asset
- intrinsic value
- 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
- reversion to the mean
- over time there is a tendency for returns and risk of asset markets to revert to average levels
- risk order of investments
- t-bills, govt bonds, corporate bonds, large comp stock, small comp stock
- ibbotson and sinquefield study
- show the direct relationship between the expected return of an asset and the risk associated with receiving that return
- correlation
- measures the degree to which the movements of variables are related, measured on a scale of -1.0 to +1.0
- efficient frontier
- achieving the highest return for each level of risk
- meir statman study
- showed that just holding 10 stocks greatly reduces volatility compared to the standard deviation for an individual stock
- rate of return calculation
- (cash payment + change in price)/price paid
- standard deviation of return
- statistic that is normally used to measure how widely or tightly the observed stock returns cluster around the average stock return
- E(Ri)=
- Rf + Bi(Rm-Rf)
- zero talent line
- risk-return line with S&P 500 and T-bills, performance below line is poor
- weak form efficiency
- implies that stock prices reflect the information contained in the history of past stock prices and trading volume, implies that daily stock price changes are independent and thus it is useless for investors to try to detect and exploit trends in stock prices, random walk hypothesis
- semi-strong form efficiency
- indicates that stock prices should reflect all publicly available information, stock prices react very quickly to new disclosures thereby prohibiting investors from earning abnormal returns
- strong form efficiency
- stock prices reflect all information, including information not available to the investment community
- behavioral finance
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show that stock markets were not efficient and people and markets, at times, behave irrationally
investors hate to lose and hold on to losing stock positions longer than they should, are ill-informed, overconfident and overoptimistic in their stock picking abilities - evidence from mutual funds
- a mutual fund customer can on average earn the highest alpha by choosing the funds with the lowest fees
- evidence from individual investors
-
Brad Barber and Terrance Odean's study
individual investor can improve returns by reducing transactions costs to the lowest level possible - indenture
- the legal agreement between the issuer of the bonds and the investors
- fixed rate discount bond
- bond is issued at an interest rate that creatse a market value of less than par at the time of pricing, and offering a yield thati s 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
- duration
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measures the price volatility of a debt issue, measured in units of time, duration of a zero coupon bond is equal to tis current time to maturity
= (-change in dollar price of a bond/dollar price of a bond)/change in market yield - taxable equivalent bond yield
-
=rate/(1-t)
t=%tax bracket - pure expectations hypothesis
- yield curve can be analyzed as a series of expected future short-term interest rates that will adjust in way such that investor will receive equivalent holding period returns
- liquidity preference hypothesis
- in order to induce investors to hold bond swith longer maturities, the issuer must pay a higher interest rate as a liquidity premium
- market segmentation hypothesis
- recognizes that the market is composed of diverse investors, issuer must pay a premium
- bond yield calculation
- =Risk-free security + spread to treasuries + bond specific spread
- value of a perpetuity
- =annual cash flow/discounting rate
- stock valuation depends most on...
- profits and interest rates