Bond
A legally binding agreement between a borrower and a lender that specfies the par value, coupon rate, coupon payment, and maturity date
What does a bond specify?
Par value, coupon rate, coupon payment, maturity date
What is the yield to maturity?
The required market interest rate on the bond
Bond value
This is determined by the present value of the coupon payments and the par value
What happens when the YTM is less than the coupon?
The bond trades at a premium
What happens when the YTM equals coupon?
The bond trades at bar
Which direction do bond prices and market interest rates move?
Opposite directions
What happens when coupon rate = YTM?
Price = par value
What happens when coupon rate is greater than YTM?
Price is greater than par value (Premium bond)
What happens when coupon rate is less than YTM?
Price is less than par value (discount bond)
Price risk
Change in price due to changes in interest rates
Which bonds have more price risk? Long term or short term?
Long term
Which bonds have more price risk? Low coupon rate or high coupon rate?
Low coupon rate
Reinvestment rate risk
Uncertainty concerning rates at which cash flows can be reinvested
Which has more reinvestment risk? Long term or short term bonds?
Short term
Which has more reinvestment risk? High coupon rate bonds or low coupon rate bonds?
High coupon rate bonds
Yield to maturity (YTM)
The rate implied by the current bond price
Current yield formula
Annual coupon/ price
YTM formula
Current yield + capital gains yield
Treasury securities
Federal government debt
T-bills
Pure discount bonds with original maturity less than one year
T-notes
Coupon debt with original maturity between one and ten years
T-bonds
Coupon debt with original maturity greater than ten years
Municipal secuirites
Debt of state and local governments
Where is interest received tax exempt?
Federal level
Corporate bonds
Greater default risk relative to government bonds
The PV of common stocks
The value of any asset is the pv of its expected future cash flows
Where does stock ownership produce cash flows?
Dividends and capital gains
What happens in a no growth example?
Assume that dividends will remain at the same level forever
What happens in a constant rate example?
Assume that dividends will grow at a constant rate, g, forever
What happens in a differential growth example?
Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter
Dividend yield
Income/beginning price
Capital gains yield
(ending price - beginning price)/ beginning price
Total percentage return
Dividend yield + capital gains yield
Total dollar return
Income from investment + capital gain (loss) due to change in price
Strong form EMH
Prices reflect all information, including public and private. Investors could not earn abnormal returns regardless of information they have
Semistrong form EMH
Prices reflect all publicly available information including trading info, annual reports, press releases. Investors cannot earn abnormal returns by trading on public info.
Weak form EMH
Prices reflect all past market information such as price and volume. Investors cannot earn abnormal returns by trading on market info
Systematic risk
Risk factors that affect a large number of assets
Other names for systematic risk?
Non-diversifiable risk or market risk
Unsystematic risk
Risk factors that affect a limited number of assets
Other names for unsystematic risk?
Unique risk and asset-specific risk
Diversifiable risk
The risk that can be eliminated by combining assets into a portfolio
Total risk
Systematic risk + unsystematic risk
For well-diversified portfolios how much of the portfolio is unsystematic risk?
A very small and low amount
Total risk is equivalent to what in a diversified portfolio?
Systematic risk
Risk premium
Expected return - risk free rate
The higher the beta?
The greater the risk premium should be