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128 Cards in this Set
- Front
- Back
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Proxy fight
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a war waged by activist shareholders to change the people elected to a firm's board
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Stock Option
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managers given the option to buy shares in a company at a fixed price for a period of time as a form of compensation
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What three things facilitate the movement of capital?
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1. financial institutions (i..e commercial banks, mutual funds)
2. financial instruments (i.e. derivatives, stocks) 3. financial markets |
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What is the difference between a 401k and a pension fund?
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A 401k is a defined contribution plan, where the employer helps contribute funds, matching employee's.
A pension fund is a defined benefit plan (i.e. you get $x a month after retirement) A shift from 401k's to pension funds has shifted the market risk from the employer to the employee. |
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Examples of securities
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stocks, bonds, CD's, mortgages, leases, derivatives and commercial paper; money, loan, etc.
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Commercial paper
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a loan from one big company to another without collateral; these are short term (typically 270 days maximum) and there is a very big market for these
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Derivative
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Any security that derives its value from another asset (i.e. a stock option, commodities future)
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Commodities future
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A contractual agreement to pay $x for oil for n years, for example. This defers risk of price fluctuation over the defined period
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Commodity
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a tangible good
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What is the difference between money and capital markets?
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Money markets are short term (less than one year), and capital markets are long term (more than one year)
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Are bonds sold in the money or capital market?
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Capital market, because bonds are long term
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Are bonds usually sold in a public or private market?
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Private
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Bond
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a borrowing/loan--incurring debt
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Stocks
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reflect ownership in the company (equity)
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What are the four components that differentiate stocks from bonds
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1. Payment methods (bonds pay interest, stocks pay dividends)
2. Voice (only stockholders have voting rights within the company) 3. Claim/priority (bond holders are paid first) 4. Tax treatment (interest paid out under bonds is tax deductible --> you pay taxes after subtracting out interest; stock dividends are NOT tax deductible; however, interest is a contractual obligation, dividends are not) |
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What marks a perfectly efficient market?
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All stocks' perceived value/market price is equal to their true/intrinsic value.
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What are the three efficient market hypotheses?
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1. Weak Form EMH
2. Semi-Strong Form EMH 3. Strong-Form EMH |
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Weak Form EMH
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Posits that all past stock price movements are embodied in a stock's price
People who embrace this give no bearing to stock analysts |
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Semi-Strong Form EMH
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Posits that stock prices reflect all publicly available information --> you must have private info to achieve excess returns
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Strong Form EMH
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Posits that all public and private information is reflected in a stock's price; this implies that insider trading could not yield excess returns, because the "insider information" is already reflected in the price
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What terms denote short-, intermediate-, and long-term securities?
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Bill = short term
Note = intermediate term Bond = long-term |
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Is a stock in the capital or money market?
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Capital--because there is no expiration/maturity date
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How are risk and return related?
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They are directly proportional
As risk increases, buyers require that expected return increases as well |
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What are the two components of return?
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1. Periodic income
2. Capital gain or loss |
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Periodic income
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(one of the two components of return)
interest or dividend paid out for a bond or stockholder |
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Capital gain or loss
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The difference between what you bought an asset for and sold it for
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What is the difference between realized and unrealized capital gain/loss
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A capital gain/loss is only realized if you have sold the asset and assumed the gain or loss. The gain/loss is unrealized if your asset has gained/lost value, but you are still holding it at the time
**You only pay taxes on realized capital gains |
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Why is return expressed as an annual percentage rate (APR)?
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To promote comparability of different assets/investments
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Is APR typically expressed as a nominal or real rate?
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Nominal
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What is the difference between nominal and real rates?
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Real rates include a deduction for inflation
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What is used to quantify risk?
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Standard deviation
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Standard Deviation =
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Std. Dev = SUM OF:
(Outcome - Expected Value)^2 * (Probability of Occurrence) |
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Coefficient of Variation
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a coefficient used to determine the risk per unit of return
Equal to the standard deviation over the expected rate of return |
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The lower the coefficient of variation....
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the less risky an investment is
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Nondiversifiable risk
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Market risk; this risk is inherent to the market, and cannot be "diversified away" with a varied portfolio
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Diversifiable risk
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risk that is unique to a company or industry
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Beta
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the correlation between a stock and the stock market (or a market index)
If... Beta = 1, stock cycles perfectly with market Beta = .5, stock is half as volatile as the market Beta = 2, stock is twice as volatile as the market |
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What is beta rarely negative?
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Because of common market factors that effect all companies
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How do betas compare between luxury and necessity companies?
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Luxury companies have higher betas, and necessities have lower betas.
This makes sense--a decline in the market will cause a huge drop in people's vacationing expenditures, while it will largely not effect their water consumption |
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Required return on an investment =
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r = RFR + [(RRM - RFR) * b)]
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How does the shape of a probability distribution convey the certainty of return?
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A very flat and broad probability distribution indicates a very uncertain return
A probability distribution with a clear and narrow peak indicates a very certain return |
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Nominal, Quoted, Real
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Nominal Interest Rates = Quoted Interest Rates
The "real rate" subtracts out inflation |
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Nominal Interest Rate =
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Nom IR = RRF + Inflation Expectations + Risk Premiums
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What are the various risk premiums?
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Default risk premium
Liquidity risk premium Maturity risk premium |
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How are interest rates and inflation related?
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They are directly correlated
As inflation increases, interest rates increase |
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Why are long term interest rates generally larger than short term interest rates?
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Because of the maturity risk premium--investor's are taking a greater risk by locking up their money for a longer period of time
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What does a yield curve determine?
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For static risk, how does maturity influence the return of an asset. In other words, all else held constant, how does the length of time I hold the asset influence the percentage of return I receive
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What is the general yield curve slope and why?
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The general yield curve is upward sloping because of the maturity risk premium
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What does a flat or inverted yield curve generally indicate
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This is generally a precursor for a recession
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What is the difference between the nominal and real risk-free rates?
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Nominal RFR - Inflation = Real RFR
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What are the three areas of finance?
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1. Financial Management
2. Capital Markets 3. Investments |
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What are the three categories of study under investments?
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1. Security Analysis (finding the proper values of individual securities)
2. Portfolio theory (the best way to structure portfolios of securities) 3. Market Analysis (are security prices too high/low?) |
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Behavioral Finance
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an area of study that looks at investor psychology and the resulting market implications
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What are the four main types of business organizations?
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1. Sole Proprietorship
2. Partnership 3. Corporation 4. Limited Liability Company/Partnership |
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What are the pros and cons of a sole proprietorship
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ADVANTAGES:
easily and inexpensively formed few government regulations lower income taxes DISADVANTAGES: unlimited personal liability life of the company is limited to the creator's life new equity/ownership requires business restructuring hard to acquire large sums of capital |
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What are the taxation implications for a corporation?
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Most corporations earnings are subject to double taxes --> the corporation's earnings are taxed, and when after-taxed earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders
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S Corporations
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Corporations that are taxed as if they were partnerships
*to qualify, the number of stockholders must not exceed 75 |
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LLP
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Limited Liability Partnership--hybrid between a partnership and a corporation; used specifically in the fields of accounting, law and architecture (LLC is everything else)
limited liability, partnership taxation |
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What are the three main benefits of a corporation when compared against other business forms?
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1. Limited liability (as risk decreases, value increases)
2. Acquiring capital is easy, and acquiring this capital promotes growth 3. Ownership is very liquid (it's easy to sell your stocks back) |
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What are the four factors that influence stock prices?
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1. Managerial actions
2. Economic environment 3. Taxes 4. Political climate |
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Intrinsic Value
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an estimate of a stock's "true" value as calculated by a competent analyst who has the best available risk and return data; intrinsic value is LONG-TERM
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Market Price
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the actual market price based on perceived but possibly incorrect information as seen by the marginal investor
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Marginal Investor
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an investor whose view determine the actual stock price
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What is equilibrium and what are its implications?
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Equilibrium occurs with the intrinsic value = the market value
At this point, investors are indifferent between buying and selling a stock |
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What are four business trends impacting the financial world?
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1. Increased CEO/CFO accountability for accurate financial reports (Sarbanes-Oxley)
2. Increased globalization 3. Improving IT 4. Corporate Governance (the way top managers operate and interface with stockholders) --> stockholders now have a bigger voice regarding management changes and transparency |
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What are three useful motivation tools to align the goals of managers with the goals of stockholders?
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1. Reasonable compensation packages
2. Firing of managers who don't perform well 3. Threat of hostile takeovers |
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Corporate Raider
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an individual who targets a corporation for takeover because it is undervalued
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Hostile Takeover
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the acquisition of a company over the opposition of it's management
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What is the "sticky situation" managers often face when trying to please their shareholders?
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Managerms must try to communicate the intrinsic value of a stock effective (especially if market value is low) without divulging competitive secrets (i.e. a newly developed technology that will triple returns in 2 years)
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What are the different interests of bond vs. stockholders regarding a company's decisions
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Bondholders seek to limit a firm's use of additional debt and constrain managers actions in order to limit risk
This is because bondholders typically receive fixed payment regardless of how well the company does (as long as it doesn't go completely bankrupt), while stockholders do better when the company does better |
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What are the three ways by which capital flows?
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1. Direct transfers of money and securities
2. Transfers thru an investment bank 3. Transfers thru a financial intermediary |
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Direct Transfers
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occurs when a business sells its stocks or bonds directly to savers (investors) without going though any type of financial institution
this procedure is mainly used by small firms and relatively little capital is raised by direct transfers |
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Primary Market Transaction
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transfers through an investment bank, which underwrites the issue
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What denotes a short-, intermediate-, and long-term note?
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Short-term: less than one year
Intermediate-term: 1-10 years Long-term: more than 10 years |
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Private Markets
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markets in which transactions are worked out directly between two parties (i.e. bank loans and insurance company private debt placements)
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Public Markets
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Markets in which standardized contracts are traded on organized exchanges
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What have technological advances and globalization of banking and commerce done to the financial world?
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It has led to deregulation, which has increased competition throughout world
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What are the three factors that complicate the coordination of regulators at the international level?
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1. The different structures in nation's banking and securities industries
2. The trend toward financial services conglomerates, which obscures developments in various market segments 3. The reluctance of individual countries to give up control over their international monetary policies |
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Investment Banks
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an organization that underwrites and distributes new investment securities and helps businesses obtain financing
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Commercial Banks
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The traditional department store of finance serving a variety of savers and borrowers
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What are the three ways by which capital flows?
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1. Direct transfers of money and securities
2. Transfers thru an investment bank 3. Transfers thru a financial intermediary |
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Direct Transfers
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occurs when a business sells its stocks or bonds directly to savers (investors) without going though any type of financial institution
this procedure is mainly used by small firms and relatively little capital is raised by direct transfers |
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Primary Market Transaction
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transfers through an investment bank, which underwrites the issue
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What denotes a short-, intermediate-, and long-term note?
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Short-term: less than one year
Intermediate-term: 1-10 years Long-term: more than 10 years |
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Private Markets
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markets in which transactions are worked out directly between two parties (i.e. bank loans and insurance company private debt placements)
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Public Markets
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Markets in which standardized contracts are traded on organized exchanges
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What have technological advances and globalization of banking and commerce done to the financial world?
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It has led to deregulation, which has increased competition throughout world
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What are the three factors that complicate the coordination of regulators at the international level?
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1. The different structures in nation's banking and securities industries
2. The trend toward financial services conglomerates, which obscures developments in various market segments 3. The reluctance of individual countries to give up control over their international monetary policies |
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Investment Banks
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an organization that underwrites and distributes new investment securities and helps businesses obtain financing
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Commercial Banks
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The traditional department store of finance serving a variety of savers and borrowers
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Financial Service Corporations
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Large conglomerates that combine many different financial institutions within a single corporation (i.e. insurance company, Smith Barney, etc.)
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Credit Unions
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cooperative associations whose members are supposed to have a common bond; members savings are loaned out only to other members (usually for large asset purchases)
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Pension Funds
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retirement plans funded by corporations or government agencies for these workers and administered primarily by the trust departments of commercial banks or by life insurance companies
Pension funds invest primarily in bonds, stocks, mortgages, and real estate |
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Life Insurance Companies
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taking savings in the form of annual premiums, invest these funds in stocks, bonds, real estate and mortgages, and make payments to beneficiaries of the insured parties
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Mutual Funds
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Organizations that pool investor funds to purchase financial instruments and this reduce risk through diversification
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Money Market Funds
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Mutual funds that invest in short-term, low risk securities and allow investors to write checks against their accounts
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Exchange Traded Funds (ETFs)
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similar to mutual funds; ETF's buy a portfolio of stocks of a certain type, and then sell their own share to the public; generally traded in the public market
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Hedge Funds
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similar to mutual funds, but unregulated, higher buy-in, and higher risk
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Private Equity Companies
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Organizations that operate like hedge funds but rather than buying some of the stocks of a firm, they buy and manage the entire firms
*most of the money is borrowed, and there is little to no regulation |
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Dealer Market
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Includes all facilities that are needed to conduct security transactions, but the transactions are not made on the physical location exchanges
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What are the three components of a dealer market?
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1. Relatively few dealers who hold inventories of these securities
2. Thousands of brokers who act as agents in bringing the dealers together with investors 3. The computers, terminals, and electronic terminals that provide a common link between brokers and dealers |
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Bid-ask spread
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the difference between bid and ask prices; denotes the dealer's mark-up, or profit
*volatile or infrequently traded stocks have a wider spread to compensate for the risk assumed by the dealer while holding it in inventory |
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Closely Held Corporation
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A corporation that is owned by a few individuals who are typically associated with the firm's management
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Publicly Owned Corporation
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A corporation that is owned by a relatively large number of individuals who are not actively involved in the firm's management
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What are the three types of stock transactions?
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1. Outstanding shares that are traded (secondary market)
.2 Additional shares sold by a public company (primary market) 3. Initial Public Offering (primary market) |
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Market Cap
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The total value of a company's stock
= (# of outstanding shares) * (market price per share) |
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How does the size of a company influence its efficiency?
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The larger the company, the more efficient its stock market is because more analysts follow it, therefore there is more information present
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What are the four factors that influence the cost of money?
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1. Production opportunities
2. Time preference for consumption 3. Risk 4. Inflation |
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what are the four things on which interest rates paid to savers depend
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1. the rate of return that producers expect to earn on invested capital
2. saver's time preference for current versus future consumption 3. the riskiness of the loan 4. the expected future rate of inflation |
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What happens to inflation and interest rates in a period of economic expansion?
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There is a high demand for capital by firms, so inflation increases, and interest rates increase
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Nominal IR=
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Quoted IR = RFR + IP + DRP + LP + MRP
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What are changes in the real return on risk free securities based on?
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1. the rate of return that corporations and borrowers expect to earn on productive assets
2. people's time preferences for current versus future consumption |
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How are the prices of long-term bonds and interest rates related?
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Inverse correlation
As interest rates increase, the price of a long-term bond decreases |
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Reinvestment Rate Risk
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the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested (this is a risk of short-term bonds, because long-term bonds hold a constant interest rate)
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Yield Curves
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a graph showing the relationship between bond yields and maturities
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What are the two things yield curve slope depends on?
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1. Expectations about future inflation
2. Effects of maturity on a bond's risk |
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Pure Expectations Theory
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A theory that states that the shape of the yield curve depends on the expectations about future interest rates (ignores the maturity risk premium)
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How is the demand for funds correlated with interest rates?
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directly proportional
As the demand for funds increases, interest rates increase |
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What are the macroeconomic factors that impact interest rates and the shape of the yield curve
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1. Federal Reserve Policy
2. Federal Budget Deficits or Surpluses 3. International Factors 4. Business Activities |
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how are government deficits related to interest rates
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as a deficit increases, interest rates increase (because the government has an increased demand for funds
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What are the three things the P/E ratio depends on?
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1. Interest Rates
2. Earnings growth rate 3. Investor's optimism/pessimism |
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Expected rate of return
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a statistical expectation of an asset's growth; the weighted average of the probability distribution of possible results
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Actual rate of return
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(prior to the asset's maturity) this is a range indicating the spectrum of the asset's potential performance
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Risk Premium
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the difference between the expected rate of return on a given risky asset and that on a less risky asset
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Capital Asset Pricing Model (CAPM)
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a model based on the proposition that any stock's required rate of return is equal to the risk free rate plus a risk premium that reflects only the risk remaining after diversification
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Realized Rate of Return
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the return that was actually earned during some past period
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Correlation Coefficient
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the degree of relationship between two variables
p = -1.0 --> perfectly negative (exact opposite performance) p = 1.0 --> perfectly positive (exactly identical performance) |
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Relevant Risk
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the risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. it is measured by the extent to which the stock moves up or down with the market
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