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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


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


threestep 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 pricebuy
if value if less than pricesell 

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 longterm 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 tbills or the average amount by which an investment has outperformed tbills in the past


beta

risk, marketrelated/systematic, slope of stock return to market return


alpha

observed return of assetexpected 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 semiannually 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 tbond 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, shorterterm 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 mptbelief 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


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

tbills, 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


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


E(Ri)=

Rf + Bi(RmRf)


zero talent line

riskreturn line with S&P 500 and Tbills, 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


semistrong 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 illinformed, 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

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/(1t)
t=%tax bracket 

pure expectations hypothesis

yield curve can be analyzed as a series of expected future shortterm 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

=Riskfree 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
