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94 Cards in this Set
- Front
- Back
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Risk Neutral Investors
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investors that prefer investments with higher returns whether or not they have risk. These investors disregard risk.
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Risk-Seeking Investors
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Investors that prefer to take risks and would invest in a higher risk investment despite the fact that a lower risk investment might have the same return.
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Arithmetic average return
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computed by simply adding the historical returns for a number of periods and dividing by the number of periods.
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Geometric Average Return
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depicts the compound annual return earned by an investor who bought the asset and held it for a number of historical periods.
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Unsystematic Risk
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risk that exists for one particular investment or a group of like investments.
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Systematic Risk
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relates to market factors that cannot be diversified away.
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Beta
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a standardized measure that has been developed to estimate an investment's systematic risk.
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Risk Preference Function
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describes an individual investor's trade off between risk and return.
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Credit or Defautl Risk
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the risk that the firm will default on paymen of interest or principal of the loan or the bond. 2 parts- the firm's creditworthiness, and the sector risk(the risk related to the economic conditions in the firm's sector)
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Interest Rate Risk
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the risk that the value of the loan or bond will decline due to an increase in interest rates.
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Market Risk
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the risk that the value of the loan or bond will decline due to a decline in the aggregate value of all the assets in the economy.
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Stated Rate
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the contractual rate charged by the lender.
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Effective Annual Interest Rate
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the true annual return to the lender.
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Normal Yield Curve
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an upward sloping curve in which short term rates are less than intermediate term rates which are less than long term rates.
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Inverted Yield Curve
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A downward sloping curve in which short term rates are greater than intermediate term rates which are greater than long term rates.
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Flat Yield Curve
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a curve in which short term, long term, , and intermediate term rates are all about the same.
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Humped Yield Curve
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a curve in which intermediate term rates are higher than both short term rates, and long term rates.
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Liquidity preference theory
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states that long term rates should be higher than short term rates, becaue investors have to be offered a premium to entice them to hold less liquid and more price sensitive securities.
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Market Segmentation Theory
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states that treasury securities are divided into segments by the various financial institiutions investing in the market.
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Expectations Theory
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This theory explains yields on long term securities as a function of short term rates.
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Derivatives
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a financial instrument or contract whose value is derived from some other financial measure(stock prices, interest rates), and includes payment provisions.
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Options
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a derivative, that allows but does not require the holder to buy or sell a specific or standard commodity at a specified price during a specified period of time.
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Forwards
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a derivative, a negotiated contract to purchase and sell a specific quantity of a financ. instum. at a price specified at orgination of the contract.
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Futures
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a derivative, forward based standardized contracts to take delivery of a specified fin. instr. at a specified date at the then market price.
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Currency Swaps
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forward based contracts in which two parties agree to exchange an obligation to pay cash flowsin one currency for an obligation to pay in another currency.
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Interest Rate Swaps
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forward based contracts in which two parties agree to swap streams of payments over a specified period of time.
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Swaption
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a derivative, an option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap.
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Risks in Using Derivatives
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1)Credit Risk
2)Market Risk 3)Basis Risk 4)Legal Risk |
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Credit Risk
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risk of a loss as a result of the counterparty to a derivative agreement failing to meet its obligation
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Market Risk
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risk of loss from adverse changes in market factors that affect the fair value of a derivative, such as interest rates, foreign exhcange rates, and market indexes for equity securiteies.
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Basis Risk
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risk of loss from ineffective hedging activities. Difference between fair value of the hedged item and the fair value of the hedging derivative.
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Legal Risk
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the risk of loss from a legal or regulatory action that invalidates or otherwise precludes performance by one or both parties to the derivative agreement.
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Speculation
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as an investment to speculate on price changes in various markets.
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SFAS 133
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requires an entity to report all derivatives as assets and liabilities in the statement of financial position, measured at fair value. Unrealized gains and losses attributed to changes in a derivative's fair value are accounted for differently, depending on whether the derivative is designated and qualifies as a hedge.
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Fair Value hedge
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a hedge of the changes in the fair value of a reconginzed asset or liability.
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Cash Flow Hedge
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a hedge of the variability in the cash flows of a recognized asset or liability, or of a forecasted transaction.
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Foreign Currency hedges
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a FV hedge of an unrecognized firm commitment valued in a foreign currency.
-a hedge of a net investment in a foreign operation. |
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Accounting for a fair value hedge
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change in FV of a derivative designated and qualifying as a FV is recognized in earnings and is offset by the portion of the change in the fair value of the hedged asset or liability.
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Accounting for a cash flow hedge
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the effective portion of the change in the fair value of a derivative designated, and qualifying as a cash flow hedge is reported in other comprehensive income, and the ineffective portion is reported in earnings.
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Black Scholes option pricing model
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a mathematical model for estimating the price of stock options using five variables.
-time to expration of the option -exercise price -risk free interest rate -price of underlying stock -volatility of the price of underlying stock. |
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Zero coupon method
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is used to determine the fair value of interest rate swaps.
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FV of an amount(future value of $1)
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the amount that will be available at some later point if an amount is deposited today computing interest for n periods.
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PV of a future amount(present value of $1)
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the pv of a future amount is the amount that you would pay now for an amount to be received "n" periods in the future given at an interest rate of "i".
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Compounding
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when interest is compounded more than once a year, two extra steps are needed. First, multiply "n" by the number of times interest is compounded annually. Second, divide "i" by the number of times interest is compounded annually. This will give u the appropriate interest rate for each period.
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Future Value of an Ordinary Annuity
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the amount available "n" periods in the future as a result of the deposit of an amount(A) at the end of every period 1 through "n". Compound interest is earned at the rate of "i" on the deposits.
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Present Value of an Ordinary Annuity
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the value today, given a discount rate, of a series of future payments
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Risks in Using Derivatives
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Credit Risk
Market Risk Basis Risk Legal Risk |
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Credit Risk (Derivative)
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risk of loss as a result of the counterparty to a derivative agreement failing to meet its obligation
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Market Risk(Derivative)
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risk of loss from adverse changes in market factors that affect fair value of a derivative.
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Basis Risk (Derivative)
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risk of loss from ineffective hedging activities.
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Legal Risk(Derivative)
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risk of loss from a legal or regulatory action that invalidates one or both parties to the agreement.
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Uses of Derivatives
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1)Speculation
2)Hedging |
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Speculation
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as an investment to speculate on price changes in various markets.
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Hedging
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to mitigate a business risk that is faced by the firm. A defensive strategy that protects an entity against the risk of adverse changes in the fair values of cash flows, assets, liabilities, or future transactions.
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Black Scholes Pricing Model
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a mathematical model for estimateing the price of stock options using five variables.
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5 Variables for Black Scholes Pricing Model
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-time to expiration of the option
-exercise price -risk free interest rate -price of the underlying stock -volatility of the price of the underlying stock |
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Zero Coupon Method
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is used to determine the fair value of interest rate swaps.
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Future value of 1
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the future value of an amount is the amount that will be available at some point in the future.
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Present value of 1
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the amount u would pay now for an amount t be received "n" periods in the future.
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Compounding
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Multiply n time the number of times interest is compounded annually. This gives the total number of interest periods. Second, divide the interest by the number of times interest is compounde annually. This will give u the appropriate interest rate for each period.
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Future Value of an Ordinary Annuity
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the amount available "n" periods in the future as a result of a deposit amount at the end of every period.
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Present Value of an Ordinary Annuity
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the value today, given a discount rate, of a series of future payments. A common application is lease payments.
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Capital Budgeting (6 stages)
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1)identification stage
2) Search stage 3)Info-Acquisition stage 4)Selection stage 5)Financing Stage 6)Implementation and Control Stage |
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Identification Stage
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mgt determines the type of capital projects that achieve mgt's goals.
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Search Stage
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mgt attempts to identify alternative capital investments that will achieve mgt's objectives.
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Information-Acquisition Stage
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Mgt attempts to revaluate the various investments in terms of their costs and benefits.
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Selection stage
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mgt chooses the projects that best meet the criteria established.
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Financing Stage
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mgt decides on the best source of funding for the project.
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Implementation and Control Stage
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mgt undertakes the project and monitors the performance of the investment.
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Sunk(Unavoidable Costs)
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committed costs that are not avoidable and are therefore irrelevant to the decision process.
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Avoidable costs
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costs that will NOT continue to be incurred if a department or product is terminated.
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Committed Costs
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arise from a company's decision to open its doors and engage in business.
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Discretionary Costs
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fixed costs whose level is set by mgt decision. (research and development)
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Relevant costs
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are future costs that will change as a result of a specific decision.
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Differential cost
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the difference in cost between two alternatives.
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Opportunity Cost
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the maximun income or saving foregone by rejecting an alternative.
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Alternative Investing Decisions
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1) Payback Method
2)Accounting Rate of Return 3)Net Present Value 4)Excess Present value index 5)Internal rate of return |
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Payback Method
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evaluates investments on the length of time until recapture of the investment.
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Advantage of Payback Method
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it is easy to calculate and understand
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Disadvantages of Payback Method
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-ignores total project profability, and shareholder value
-does not take into account the time value of money. |
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Discounted Payback Method
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same as payback method except, cash flows are first discounted to their present value.
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Accounting Rate of Return
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ARR method computes an approximate rate of return which ignores the time value of money.
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Disadvantages of ARR method
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-results are affected by the depreciation method used.
-makes no adjustment for project risk -no adjustment for the time value of money. |
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Net Present Value
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a discounted cash flow method which calculates the present value of the future cash flows of a project and compares this with the investment outlay required to implement the project. Requires a minimum rate of return that mgt is willing to accept on its investments.
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Excess Present Value Index
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computes the ratio of the present value of the cash inflows to the initial cost of a project.
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Advantages of Excess Present Value Index
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-results in dollars
-adjusts for the time value of money -considers the total profability of the project |
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Disadvantages of excess present value index
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-may not be as simple to understand
-doesn not take into account the management flexibility with respect to a project. |
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Internal Rate of Return
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a discounted cash flow method. It determines the rate of a discount at which the present value of the futue cash flows will exactly equal the investment outlay.
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Advantages of the internal rate of return method
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-adjusts for the time value of money
-hurdle rate is based on market rates for similar investments -results are more intuitive than the net present value method. |
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Disadvantages of the internal rate of return method
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-may be no unique internal rate of return for a particular project, there may be multiple returns.
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Probability Analysis
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a way to include risk in the capital budgeting analysis is to assign probabilities to possible outcomes.
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Coefficient of Variation
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the standard deviation divided by the expected value of the investment.
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Risk Adjusted Discount Rates
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a popular approach to adjust for risk involves using different discount rates for proposals with different levels of risk.
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Time Adjusted Discount Rates
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cash flows later in a project's life should be adjusted due to (inflation, interet rates). Cash flows are grouped together Ex:
years 1-4 years 5-8 |
