Finance 3000 Exam 2 Mizzou

compounding

value in the future
different cash flows paid in at different times

annuities

value in the future
same cash flows paid in every period

multiple cash flows

car loans and home mortgage loans
determining value of business opportunities

discounting

value of future sum today
different cash flows paid in a different times

ordinary annuity

payment occurs at the end of each period

annuity due

payment occurs at the beginning of each period

primary markets

used by corporations and government
These provide a forum in which demanders of funds raise funds by issuing new financial instruments, such as stocks and bonds.

secondary markets

benefit investors and issuers
securities traded after issue
provide liquidity and diversification benefits for investors
security valuation information for issues
once firms issue financial instruments in primary markets, these same stocks and bonds are t

money markets

trade debt securities or instruments with maturities of one year or less

capital markets

trade stocks and long-term debt with maturities greater than one year

foreign exchange markets

trade currency for immediate delivery (spot) or for some future delivery
subject to foreign exchange risk due to currency fluctuations

derivatives

highly leveraged financial securities linked to underlying security
potentially high-risk
used for hedging and speculating

nominal interest

factors that affect this:
inflation
real interest rate
default and liquidity risk
provisions of security issuer
term to maturity
actually observed in financial markets

inflation

% increase in cost of goods or services over given period of time
inflation + nominal interest rate

actual/expected inflation rate

interest rates increase in response to inflation

twice

the u.s. bond market is over ______ the size of the US stock market

29.2 trillion

total outstanding debt in 2007

14.2 trillion

total market value of common stock

risky

in general bonds are less _________ than stocks

bonds

debt obligations
(corporations, federal government and federal agencies, states and local governments)
also known as fixed-income securities
(amount of timing of cash flows are known)

bond issuer

the bond is a loan that requires regular interest payments and repayment of the borrowed principal

call feature

allows the issuing firm to refinance when interest rates fall
the issuer "calls" the bond back prior to maturity
(pays the principal plus a call premium, which is usually one year's worth of interest payments)

coupon rate

the bond's interest rate
listed on the bond as a % of par value and determines the dollar amount of interest paid to bondholders
set at time of issue
(a 5% _________ ______ pays 5% of 1000 (or $50) each year, or $25 every six months)

par value

when first issued, bonds sell at

change

bond prices change as interest rates and firm risk _________

differ

when the bonds trade among investors in the secondary market with price will likely _______ from par value

corporate bond prices

are quoted in terms of % of par
(ex. a bond worth $1,150 would be listed at 115, which a bond worth $870 is quoted as 87)

U.S. Treasury Bonds

backed by the full faith and credit of the US government
considered safest investments in the world
federal government sells treasury securities through public auction to finance the federal deficit
are quoted in 32s of a percent

treasury bills

mature in less than one year
NOT a capital market instrument

treasury notes

mature in one to ten years

treasury bonds

mature in greater than 10 years

corporate bonds

used by corporations to raise capital
two ways to raise capital:
Equity (stock)
debt (bonds)
NOT a money market instrument

overall capital cost

firms seek to minimize their

1998

beginning in _____ they switched to raising capital by issuing bonds

municipal bonds

issued by state and local governments
(streets, highways, hospitals, schools, sewer systems)
interest is not taxed at the federal level or by the relevant state
offer lower yields compared with corporate bonds and treasury securities bc of tax exemption a

general obligation bonds

projects that benefit the entire community typically funded by
they are repaid through tax revenues

revenue bonds

projects that benefit certain groups, such as toll roads and airports are typically funded by
repaid from user fees

Treasury Inflation-Protected Securities (TIPS)

indexed to inflation
first issued in 1997
have fixed coupon rates
federal government adjusts the par value to adjust for inflation reflected by changes in the CPI
as par value changes over time, so do the interest payments
total return comes from the inte

U.S. government agency securities

student loans, fannie mae, freddie mac
issue debt to provide low-cost financing for home ownership, education, and farming
issued to support particular sectors of the economy
they do not carry the full-faith-and-credit guarantee of the federal government

Mortgage-backed securities (MBS)

agencies that offer subsidies or mortgage guarantees for people who wouldn't otherwise qualify for mortgages
increase the amount of money available for the home mortgage market by purchasing home mortgages from banks and other lenders

premium bond

sells for higher price than par
bonds that sell for more then $1,000

discount bond

sells for lower price than par
bonds that sell for less than $1000

price of bond

present value of future cash flows discounted at prevailing market interest rate

determine coupon rate

the amount of uncertainty about whether the company will be able to make all of the payments (default risk)
the term of the loan
the level of interest rates in the overall economy at the time

bond valuation

represents the present value of future cash flows
easier to value than stocks bc the cash flows are known
(coupon amount & par value)

present value of bond

present value of interest payments + present value of par value

fall

if interest rates rise after a bond is issued, the bond's price would have to _____ in order to enable a purchaser to obtain the new, higher market yield

rise

when interest rates fall, the market prices for outstanding bonds _______ to bring the offered return on older bonds with higher coupons in line with new issues

interest rate risk

the change in bond prices as a result of changes in prevailing interest rates
does not affect all bonds equally
short-term bonds are less affected

current yield

measure the portion of total return that is due to the coupon interest payments
it ignores the portion of return due to price changes, or capital gains
=annual coupon/bond price

yield to maturity (YMT)

discount rate that equates the present value of future cash flows with current bond price
when bond price falls, this increases

yield to call

price of callable bond = present value of interest payments to call data + present value of call price
if the bond is called by the issuer prior to maturity, the investor would receive only the coupon payments up to the point of call, plus the call price

callable bonds

are an advantage for the issuer, but a disadvantage for the investor
if interest rates fall, the issuer can recall the more expensive debt and issue a new debt at the new lower interest rate
the investor is left with cash, just when interest rates are low

equivalent taxable yield

0

bond ratings

measure of an issuer's credit quality
bond rating agencies (moody's and standard & poor's) monitor debt and report their findings as a grade or rating
(issuers' financial condition, general economic conditions, economic value of underlying collateral)

credit risk

the chance the issuer will not be able to repay on a timely basis
investment-grade bonds are AAA to BBB rated

lower quality bonds

offer higher yields

higher quality bonds

offer lower yields

bond markets

decentralized, over-the-counter trading
most trades occur between bond dealers and large institutions
have inverse relationship to interest rates

investment banks

In the US, these financial institutions arrange most primary market transactions for businesses

derivative security

This is a security formalizing an agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future.

liquidity

ease with which an asset can be converted into cash

initial public offerings

Primary market financial instruments include stock issues from firms allowing their equity shares to be publicly traded on stock market for the first time. We usually refer to these first-time issues as

financial markets

exist to manage the flow of funds from investors to borrowers as well as from one investor to another

EAR (effective annual rate)

#NAME?

real risk-free rate

adjusts for inflation; generally lower than nominal risk-free rates at any particular time

default risk

risk that a security issuer will miss an interest or principal payment or continue to miss such payments

liquidity risk

risk that a security cannot be sold at a price relatively close to its value with low transaction costs on short notice

special provisions

impact a security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions

time to maturity

length of time until a security is repaid; used in debt securities as the date upon which the security holders get their principal back

fisher effect

theorizes that nominal risk-free rates that we observe in financial markets (e.g. the 1-year treasury bill rate) must compensate investors for:
any inflation-related reduction in purchasing power lost on funds lent or principal due
an additional premium a

unbiased expectations theory

the yield curve reflects the market's current expectations of future short-term rates

liquidity premium theory

builds on the unbiased expectations theory
investors will hold long-term maturities only if these securities with longer term maturities are offered at a premium to compensate for future uncertainty in the securities value

market segmentation theory

argues that individual investors and FIs have specific maturity preferences, and convincing them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium)
investors do not consider securities wit