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