Management Exam #2

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Production Opportunities

Back 1

The investment opportunities in productive (cash-generating) assets

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Time preferences for Consumption

Back 2

The preferences of consumers for current consumption as opposed to saving for future consumption

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Risk

Back 3

In a financial market context, the chance that an investment will provide a low or negative return

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Inflation

Back 4

The amount by which prices increase over time

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Interest rate paid to savers depends on...

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1. the rate of return that producers expect to earn on invested capital
2. savers time preferences for current vs future consumption
3. riskiness of the loan
4.expected future rate of inflation

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Quoted interest rate equation

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r=r*+IP+DRP+LP+MRP

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r in the quoted equation means...

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quoted or nominal rate of interest on a given secuirty

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r* in the quoted equation means...

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the real risk-free rate of interest. The rate that would exist on a riskless security in a world where no inflation was expected

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r RF means

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r*+IP . It is the quoted rate on a risk-free security such as a US treasury bill, which is very liquid and is free of most types of risk. The premium for expected inflation, IP, is included in r RF

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IP in the quoted equation means...

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inflation premium. IP is equal to the average expected rate of inflation over the life of the security. The expected future inflation rate is not necessarily equal to current inflation

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DRP in the quoted equation means...

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Default Risk Premium. The premium reflects the possibility that the issuer will not pay the promised interest or principal at the stated time. DRP is 0 for the US treasury securities but it rises as the riskiness of the issuer increases

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LP in the quoted equation means...

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liquidity (or marketability) premium. This is a premium charged by lenders to reflect the fact that some securtities cant be converted to cash on short notice at a "reasonable" price. LP is very low for treasury securities and for securities issued by large, strong firms; but it is relatively high on securities issued by small, privately held firms.

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MRP in the quoted equation means...

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Maturity Risk Premium. Longer term bonds, even Treasury bonds, are exposed to a significant risk of price declines due to increases in inflation and interest rates; and a maturity risk premium is charged by lenders to reflect this risk

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r RF =___+____ so the quoted nominal equation can be re-written as...

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rRF=r*+IP so r=rRF+DRP+LP+MRP

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Real Risk-free rate of interest,r*

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The rate of interest that would exist on default-free U.S.Treasury securities if no inflation were expected

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Nominal (quoted) Risk-Free rate, rRF

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The rate of interest on a security that is free of all risk; rRD is proxied by the T-bill rate or the T-bond rate. rRF includes an inflation premium

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Inflation Premium

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A premium equal to expected inflation that investors add to the real risk-free rate of return

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Default Risk Premium

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The difference between the interest rate on a US Treasury bond and a corporate bond of equal maturity and marketability

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Liquidity Premium

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A premium added to the equilibrium interest rate on a security if that security cant be converted to cash on short notice and at close to its "fair market value"

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Interest Rate Risk

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The risk of capital losses to which investors are exposed because of changing interest rates

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Maturity Risk premium

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A premium that reflects interest rate risk

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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

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Term Structure of interest rates

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The relationship b/t bond yields and maturities

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Yield Curve

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a graph showing the relationship b/t bond yields and maturities

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"normal" yield curve

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an upward-sloping yield curve

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Inverted ("abnormal") yield curve

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a downward-sloping yield curve

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Humped Yield Curve

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A yield curve where interest rates on intermediate-term maturities are higher than rates on both short term and long-term maturities

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yield on a treasury bind that matures in t years

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T-bond yield= r*t+IPt+MRPt

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Yield on a corporate bond that matures in t years

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corp bond yield=r*t+ IPt+MRPt+DRPt+LPt

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Corporate Bond Yield Spread

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corp bond yield-treasury bond yield=DRPt+LPt

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Pure Expectations Theory

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A theory that states that the shape of the yield curve depends on investors' expectations about future interest rates

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Foreign Trade Deficit

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The situation that exists when a country imports more than it exports

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Bond

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A long-term debt instrument

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Treasury bonds

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bonds issued by the federal government, sometimes referred to as government bonds

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Municipal Bonds

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Bonds issued by state and local governments

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Foreign Bonds

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Bonds issued by foreign governments or by foreign corporations

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Par Value

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The face value of a bond

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Coupon Payment

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The specified number of dollars of interest paid each year

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Coupon Interest Rate

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The stated annual interest rate on a bond

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Fixed-Rate Bond

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A bond whose interest rate is fixed for its entire life

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Floating-Rate Bond

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A bond whose interst rate fluctuates with shifts in the general level of interest rates

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Zero Coupon Bond

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A bond that pays no annual interest but is sold at a discount below par, thus compensating investors in the form of capital appreciation

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Original Issue Discount (OID) Bond

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Any bond originally offered at a price below its par value

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Maturity Date

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A specified date on which the par value of a bond must be repaid

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Original Maturity

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The number of years to maturity at the time a bond is issued

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Call Provision

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A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date

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Sinking Fund Provision

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A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year

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Convertible Bond

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A bond that is exchangable at the option of the holder for the issuing firms common stock

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Warrent

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a long-term option to buy a stated number of shares of common stock at a specified price

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Putable bonds

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A bond with a provision that allows its investors to sell it back to the company prior to maturity at a prearranged price

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Income bond

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a bond that pays interest only if its earned

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Indexed (purchasing power) bond

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A bond that has interest payments based on an inflation index so as to protect the holder from inflation

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Discount Bond

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A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon

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Premium Bond

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A bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate

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Yield to Maturity (YTM)

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The rate of return earned on a bond it it is held to maturity

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Yield to Call (YTC)

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The rate of return earned on a bond when it is called before its maturity date

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Price (interst rate) Risk

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The risk of a decline in a bond's price due to an increase in interest rates

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Reinvestment risk

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The risk that a decline in interest rates will lead to a decline in income from a bond portfolio

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Investment Horizon

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The period of time an investor plans to hold a particular investment

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Duration

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The weighted average of the time it takes to receive each of the bond's cash flows

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Mortgage Bond

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A bond backed by fixed assets. First mortgage bonds are senior in priority to claims of second mortgage bonds

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Indenture

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A formal agreement b/t the issuer and the bondholders

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debenture

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a long term bond that is not secured by a mortgage on specific property

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subordinated debenture

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a bond having a claim on assets only after the senior debt has been paid in full in the event of liquidation

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Investment grade bond

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Bonds, rated triple-B or higher; many banks and other instituetional investors are permitted by law to hold only investment-grade bonds

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junk bond

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A high-risk, high-yield bond

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Risk

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The chance that some unfavorable event will occur

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Stand-Alone Risk

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The risk an investor would face if he or she held only one asset

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Expected Rate of Return, r

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The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results

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Probability Distribution

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A listing of possible outcomes or events with a probability (chance of occurance) assigned to each outcome

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Standard Deviation (sigma)

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a statistical measure of the variability of a set of observations

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Coefficient of Variation (CV)

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The standardized measure of the risk per unit of return; calculated as teh standard deviation divided by the expected return

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Risk Aversion

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Risk averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities

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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

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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 of return plus a risk premium that reflects only the risk remaining after diversification

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Expected Return on a Portfolio

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The weighted average of the expected returns on the assets held in the portfolio

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Realized Rate of return, rbar

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The return that was actually earned during some past period

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Correlation

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The tendency of two variable to move together

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Correlation coefficient

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a measure of the degree of relationship b/t two variables

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Diversifiable Risk

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That part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company-specific, or unsystematic, risk

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Market risk

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The risk that remains in a portfolio after diversification has elminiated all company-specific risk. THis risk is also konwn as nondiversifiable or systematic or beta risk

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Market portfolio

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A portfolio consisting of all stocks

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Relevent Risk

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The risk that remains once a stock in in a diversified portfolio is its contribution to the portfolio's market risk. Measured by the extent to which the stock moves up or down with the market

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Beta coefficient

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A metricthat shows the extent to which a given stock's returns move up and down with the stock market. Beta thus measures market risk

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Average stock's beta

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bA=1 because an average risk stock is one that tends to move up and down in step with the general market

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Market Risk premium

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The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk

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security Market Line equation

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An equation that shows the relationship b/t risk as measured by beta and the required rates of return on an individual securities

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Proxy

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A document giving one person the authority to act for another, typically to vote shares for common stock.

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Proxy Fight

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An attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote its shares to replace the current management.

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Takeover

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An action whereby a person or group succeeds in ousting a firms management and taking control of the company.

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Preemptive Right

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A provision in the corporate character or bylaws that gives common stock holders the right to purchase a pro rata basis new issues of common stock or (common securities).

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Classified Stock

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Common stock that is given to a special designation such as Class A or Class B to meet special needs of the company.

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Founders Shares

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Stock owned by the firms founders that enables them to maintain control over the company without having to own a majority of stock.

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Marginal Investor

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A representative investor whose actions reflect the beliefs of those people who are currently trading the stock. The marginal investor determines the stock price.

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Market Price-Po

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The price at which a stock sells in the market.

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Growth Rate, G

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The expected rate of growth in dividends per share.

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Required Rate of Return,rs

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The minimum rate of return of a common stock that a stock holder considers acceptable.

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Expected Rate of Return,r-hat s

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The rate of return of a common stock that a stock holder expects to receive in the future.

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Actual (realized) Rate of Return, r-bar s

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The rate of return on a common stock actually received by stock holders in some past period. R bar s may be greater than or less than r hat and or r

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Dividend Yield

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The expected dividend divided by the current price of a share of stock.

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Capital Gains Yield

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The capital gain during a given year divided by the beginning price.

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Expected Total Return

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The sum of the expected dividend yield and the expected capital gain yield.

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Constant Growth Model

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Used to find the value of a constant growth stock.

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O Growth Stock

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A common stock whose future dividends are not expected to grow at all; g=0

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Super Normal Growth

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The part of the firms life cycle in which it grows much faster as the economy as a whole.

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Horizon Date

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The date when the growth rate becomes constant. At this date it is no longer necessary to forecast individual dividends.

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Horizon Value

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The value at the horizon date of all dividends expected there after.

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Corporate Valuation Model

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A valuation model used as an alternative to the discounted dividend model to determine a firm's value, especially one with no history of dividends, or the value of a division of a larger firm. The corporate model first calculates the firm's free cash loads then finds their present values to determine the firm's value.