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67 Cards in this Set
- Front
- Back
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Percentage Return
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(Capital Gain + Dividend) / Initial Share Price
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Nominal Rate of Return
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Measures how much money you will have at the end of the year if you invest today
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Real Rate of Return
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Measures how much money you will be able to spend at the end of the year
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Market Index
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Measures the investment performance of the overall market
---The best known stock market index in the U.S. is the DOW Jones Industrial Average (DOW) |
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Treasury Bills
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**The safest investment you can make!
-Because they are issued by the government, you can be sure to get your money back -Their short-term maturity means that their prices are relatively stable -There is still some uncertainty with inflation |
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Long-term Treasury Bonds
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Certain to be repaind when they mature, but the prices of these bonds flunctuate more as interest rates vary
---When interest rates fall, the value of long-term bonds rises; when rates rise, the value of the bond falls |
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Common Stocks
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**The riskiest investment you can make!
-When you invest in common stocks, there is no promise that you will get your money back -As a part-owner of the corporation, you receive what is left over after the bonds any other debts have been repaid |
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Maturity Premium
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The extra average return from investing in long vs short-term treasury securities
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Maturity Risk Premium
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The expected return in excess of risk-free return as a compensation for risk
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Opportunity Cost of Capital
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The return that the firm's stakeholders are giving up by investing in the project rather than in comparable risk alternatives
---Since shareholders can obtain a surefire payoff by investing in a U.S. Treasury bill, the firm should invest in a risk-free project only if it can at least match the rate of interest on such a loan |
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Expected Return
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Return must provide compensation to investors for both waiting (time value of money) and for worrying (risk of the asset)
**Stocks with the same expected risk should have the same expected return |
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Variance
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The average value of squared deviations from the mean (measures volatility)
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Standard Deviation
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The square root of the variance (another measure of volatility)
---A low standard deviation means that there is little certainty about the stock's return |
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Variability
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Most individual stocks are substantially more variable than the market portfolio
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Diversification
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**Reduces variability
-The strategy designed to reduce risk by spreading the portfolio across many investments -Portfolio diversification works because prices of different stocks do not move together -Diversification works best when the returns are negatively correlated -Diversification can cut variability of returns by about half |
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Unique Risk
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-The risk that can be eliminated by diversification
-Arises because many of the perils that surround an individual company pertain solely to that company and perhaps to its direct competitors |
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Market Risk
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-The risk that you cannot avoid regardless of how much you diversify your portfolio
-Arises from economy-wide perils that threaten all businesses |
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Market Portfolio
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A portfolio of all assets in the economy. In practice, a broad stock market index is used to represent the market
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Beta
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The sensitivity of a stock's return to the return on the market portfolio
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Defensive Stocks
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Not very sensitive to market flunctuations and therefore have low Betas (B<1.0)
---Outperforming the market when the market index falls, and underperforming the market when the market index rises ---If the market goes down, it is better to have defensive stocks and your money in the bank |
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Aggressive Stocks
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Amplify market movements and have higher Betas (B>1.0)
---Outperforming the market when the market index rises, and underperforming the market when the market index falls ---If the market goes up, it is good to have aggressive stocks |
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Stock Returns
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Broken down into 2 parts:
---Market Risk: the part that can be explained by market returns and the firm's Beta (sensitivity) ---Unique Risk: the part due to new information that is specific to the firm |
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Treasury Bills and Beta vs Common Stocks and Beta
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-Treasury bills have a fixed return, so they are unaffected by what happens to the market, and thus have a Beta=0
-Common stocks are the most risky and so they have an average market risk with a Beta=1 |
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Market Risk Premium
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The difference between the return on the market and the interest rate on Treasury bills
**Market Risk Premium = Rm - Rf |
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Expected Risk Premium
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Represents the compensation for market risk (what investors can earn for the market risk)
**Risk Premium= B(Rm-Rf) |
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Expected Rate of Return
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The sum of the risk-free rate and the expected risk premium
**Expected Return= Rf + B(Rm-Rf) |
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Capital Asset Pricing Model (CAPM)
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Predicts that the risk premium should increase in proportion to Beta, so the returns of each portfolio should lie on the upward sloping security market line
---Broken down into 2 components: 1.) Stock's Risk Premium: the proportion of a stock's total return that you earn for bearing the stock's market risk 2.) Market Risk- measured by Beta |
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Security Market Line
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If a project lies above the security market line, then the return is higher than what investors would expect to earn in the project (it is attractive!)
---These stocks offer a higher rate of return for the risk taken ---Investors search for these stocks and bid up the price, causing the return to fall ---The stock's price will continue to rise until the stock's market return drops down to the security market line |
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Security Market Line
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-If the stock offered a lower rate of return, nobody would hold the stock, so its price would have to drop. Then, a lower price means a better buy for investors, that is, a higher rate of return. Therefore, the price will fall until the expected rate of return is pushed back up to the security market line.
-If the stock were higher than the security market line, then diversified investors would want to buy more of it. This would then push the price up and the expected rate of return down to the levels predicted by the security market line |
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Value and Growth Stocks
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-Value stocks are those with high ratios of book value to market value
-Growth stocks are those with low ratios of book to market value |
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Company Cost of Capital
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The expected rate of return demanded by investors in a company, determined by the average risk of the comapany's securities
---Used to discount the cash flows on all projects **Because investors require a higher rate of return from a risky company, risky firms will have a higher company cost of capital and will set a higher discount rate for their new investment opportunities |
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Project Cost of Capital
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The minimum acceptable expected rate of return on a project, given its risk
---Depends on the risk of a new business and the return that shareholders require from investing in such a business ---If a company invests in a low-risk project, then it should discount the cash flows at a correspondingly lost cost of capital ---If a company invests in a high risk project, then those cash flows should be discounted at a high cost of capital |
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Bonds
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A bond is a security that obligates the issuer to make specified payments to the bondholder
---When governments or companies issue bonds, they promise to make a series of interest payments and then repay the debt ---Bonds have a face value (par) of $1000 |
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Coupons
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An interest payment that a bondholder receives each year until the bond matures completely
---A coupon rate is a monthly, quarterly, yearly, etc. percentage of the bond's face value |
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Yield to Maturity
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A measure of the interest rate for which the present value of the bond's payments equals the price
---It is a measure of a bond's total return, including both coupon income and capital gain |
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Bond Pricing
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The value of a bond is the present value of cash flows. To find this value, you need to discount each future payment by the current interest rate
---Bond prices are usually expressed as a percentage of their face value |
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Bond Relationships
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Coupon Yield > Coupon Rate, Price < 1,000, the bond was purchased at a discount and then sold at a premium to par.
Coupon Yield < Coupon Rate, Price > 1,000, the bond was purchased at a premium and sold at a discount to par |
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Coupon Payments
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**Don't confuse the interest payment or coupon on the bond wiht the interest rate, that is, the return that investors require
---Coupon payments are fixed on our Treasury bonds when they are issued |
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Interest Rates
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-The interest rate changes daily. These changes affect the present value of the coupon payments but not the payments themselves
-A change in interest rates has a greater effect on the prices of long-term bonds than on short-term bonds ---The longer the loan, the more income you have lost by accepting what turns out to be a low interest rate. Then when interest rates fall, the long-term bond has a greater price increase |
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Interest Rates and Bond Prices
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Bond prices flunctuate as interest rates change, meaning that bonds exhibit interest rate risk
---Bond investors hope that market interest rates will fall so that the price of their bond will rise. If they are unlucky and the market interest rate rises, then the value of their investment falls |
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Current Yield
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The annual coupon payment divided by the bond price
= coupon payment / bond price |
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Bonds priced above face value
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Sell at a premium to par (P>1,000; CY<CR)
---Investors who buy a bond at a premium suffer from a capital loss over the life of the bond, and so the return on the bond is always less than the bond's current yield **Capital Loss: Bond's return < Current Yield |
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Bonds price below face value
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Sell at a discount to par (P<1,000; CY>CR)
---Investors in discount bonds have a capital gain over the life of the bond, and so the return on these bonds are always greater than the bond's current yield **Capital Gain: Bond's return > Current Yield |
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Calculating the YTM
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When calculating YTM, you use guess and check for the present value to equal price
---If the present value is greater than the actual price, then you need to increase the discount rate because it is too low ---If the present value is less than the price, then you must reduce the interest rate because it is too high **If the bond's YTM remains unchanged, then its rate of return will equal its YTM |
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Rate of Return and YTM
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The rate of return will be less than the yield to maturity if interest rates rise and it will be greater than the yield to maturity if interest rates fall
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Long-term Bonds vs Short-term Bonds
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Investors might rationally stay away from long-term bonds for 2 reasons:
1.) The prices of long-term bonds flunctuate much more than prices of short-term bonds 2.) Short-term investors can profit if interest rates rise |
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Default Risk
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The risk that a bond issuer may default on its obligations
---Companies need to compensate for this default risk by promising a higher rate of interest on their bonds |
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Default Premium
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The difference between the promised yield on a corporate bond and the yield on a U.S. Treasury bond wiht the same coupon and maturity
---The greater the chance that the company will get into trouble, the higher the default premium demanded by investors |
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Bond Ratings
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-Investment Grade: Bonds with a rating of BBB and above (have a stronger rating and the least amount of risk)
-Junk Bond: Bonds with a rating of BB and below (have a very low ranking because they are very risky and are less likely to repay the principal investment) |
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Zero-coupon Bonds
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Issued at prices well below face value and the investor's return comes from the difference between the purchase price and the payment of face value at maturity
---In this case, investors receive 1,000 face value at the maturity date, but do not receive a regular coupon payment as well because the bond has a coupon rate of zero |
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Floating-rate Bonds
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Make coupon payments that are tied to some measure of current market rates. The rate might be reset once a year to the current short-term Treasury plus 2%.
---This means that the bond's coupon rate will always approximate current market interest rates |
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Convertible Bonds
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Because they offer the opportunity to participate in any price appreciation of the company's stock, investors will accept lower interest rates on convertible bonds
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Common Stock
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Ownership shars in a publicly held corporation
---Large firms sell of issue shares of stock to the public when they need to raise money, and then shareholders share the ownership of the firm in proportion to the number of shares they hold. Shareholders benefit when the company prospers and suffer losses when it does not |
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Initial Public Offering (IPO)
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The first time the company sells shares to the public
---Companies rasie funds by selling these new shares, but the previous owners now have to share the ownership and profits of the firm with the new co-owners ---IPOs are often eagerly anticipated, as they are the first opportunity for teh general public to buy shares in hot companies that to date have been owned by founders and their private backers |
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Market Cap
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The total value of a company's outstanding shares of stock
---Large-cap and small-cap firms is a convenient way to summarize the size of the company |
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Dividend Yield
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Tells you how much dividend income you would receive for every $100 invested in the stock
---This would not be the total rate of return on your investment, as you would hope for some increase in the stock price **Similarly to the current yield of a bond, the dividend yield ignores capital gains and losses |
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Book Value
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Records all the money that a company has raised from its shareholders plus all the earnings that have been plowed back on their behalf
**Records what a company has paid for its assets less a deduction for depreciation ---The book value is the net worth of the firm according to the balance sheet |
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Liquidation Value
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The amount of cash per share a company could raise if it sold off all of its assets in secondhand markets and paid off all of its debts
**What the company could net by selling all its assets and repaying its debts ---Stock price should not equal the liquidation value because a successful company ought to be worth more than the liquidation value, since that was the goal of bringing all the assets together in the first place |
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2 key features that determine a firm's profitability
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1.) The earning that can be generated by the firm's current tangible and intangible assets
2.) The opportunities the firm has to invest in lucrative projects that wil increase future earnings |
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Market Value
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The amount that investors are willing to pay for the shares of the firm. This depends on the earning power of today's assets and the expected profitability of future investments
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Intrinsic Value
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The present value of the cash flows anticipated by the investor in the stock
**The "fair" price of the stock ---If investors buy the stock at its intrinsic value, their expected rate of return will precisely equal the discount rate, which means that their investment will just compensate them for the opportunity cost of their money |
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Stocks vs Bonds
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Unlike bonds, the final horizon date for stocks is unknown because stocks do not "mature"
---The value of a bond is the present value of its coupon payments plus the present value of its final payment at face value ---Stocks are similar in that investors receive dividends instead of interest/coupon payments and the stock price at the time they sell shares instead of face value |
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Diversification Continued
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When security returns are negatively correlated, the portfolio benefits from the risk-reducing effect of diversification, causing the standard deviation of returns for the portfolio to be less than the standard deviation of returns for each stock
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Bond Ratings Continued
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Increasing the risk on a bond will result in a higher return, which means that investors will demand a higher default premium to compensate for the added risk (the coupon rate and maturity will not change)
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Growth Stocks vs Income Stocks
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-Investors buy growth stocks in the expectation of capital gains and they are interested in the future growth of earnings rather than in nex year's dividends
-Investors buy income stocks for the cash dividends that they provide (less of the current value of income stocks is due to future growth prospects) **EPS= Book Equity per share/ROE |
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Efficient Markets
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-Investors can expect returns sufficient enough to compensate for the risks they bear
-Securities prices rapidly reflect new information -Professional investors still can earn superior returns, but not consistently over longer periods of time |
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Key Concepts to Know
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-Cannot get the portfolio standard deviation without knowing the correlation
-Efficient Markets -Yield to Maturity: relationship between current yield and coupon rate -Total Return= Dividend Yield + Capital Gain -Security Market Line -Weighted Portfolio Return |
