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74 Cards in this Set

  • Front
  • Back
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
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
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
debt instrument, corporations, us govt. and municipalities issue bonds
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
amount by which an investment to outperform t-bills or the average amount by which an investment has outperformed t-bills in the past
risk, market-related/systematic, slope of stock return to market return
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
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
call option
call option contracts enable the owner to buy an asset
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
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
risk premium
function of the stock's beta and the market risk premium (exp. return on overall stock market - risk free rate)
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
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
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
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
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

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