Bond
Security that obligates issuer to make payments to holder over time
Face Value, Par Value
Payment to bondholder at maturity of bond
Coupon Rate
Bond's annual interest payment per dollar of par value
Callable bonds
gives the issuer the right to redeem the bond before maturity at a specific price after a specific date
Convertible bonds
Allow bondholder to exchange bond for specified number of common stock shares
Puttable bonds
Holder may choose to exchange for par value or to extend for given number of years
Floating-rate bonds
Coupon rates periodically reset according to specified market date
callable bonds
convertible bonds
puttable bonds
floating-rate bonds
What are some types of corporate bonds?
State, local governments (municipal bonds)
What are some other domestic issuers of bonds?
Treasury Inflation Protected Securities (TIPS)
Par value of bond increases with consumer price index (CPI)
Bond value
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cash outflow
What does a negative PV mean when you buy?
Prices
__________ fall as market interest rate rises
Coupon rate
is fixed and does not increase when market interest rises
Interest rate fluctuations
are primary source of bond market risk
longer
Bonds with __________ maturities more sensitive to fluctuations in interest rate
Yield to Maturity (YTM)
Discount rate that makes present value of bond's payments equal to price.
Premium Bonds
Bonds selling above par value
Discount Bonds
Bonds selling below par value
Zero-Coupon Bonds
� Carries no coupons
� Provides all return in form of price appreciation
� Sold at a discount
After-Tax Returns
� Most bonds are taxed; need to calculate aftertax return
� Municipal bond, commonly known as muni bond, is usually tax-exempt
� Yields on municipal bonds are generally lower than yields on similar corporate bonds because of differences in taxation
Investment grade bond
Rated BBB and above by S&P or Baa and above by Moody's
Speculative grade or junk bond
Rated BB or lower by S&P, Ba or lower by Moody's, or unrated
Bond Indentures
Defines contract between issuer and holder
Sinking fund
Indenture calling for issuer to periodically repurchase some proportion of outstanding bonds before maturity
Dividend restriction clause
Limit the amount of dividends paid to stockholders
Subordination clause
Restrictions on additional borrowing stipulating senior bondholders paid first in event of bankruptcy
Collateral
Specific asset pledged against possible default
-indenture
-sinking fund
-dividend restriction clause
-subordination clause
-collateral
What are some bond indentures?
Default premium
Bonds with higher default risk generally have higher yields to compensate investors for default risk
Term Structure of Interest Rates
Relationship between yields to maturity and terms to maturity across bonds
Yield Curve
� Graph of yield to maturity as function of term to maturity
� is a leading economic indicator (used in making forecasts about the economy)
Expectations Hypothesis
Yields to maturity determined solely by expectations of future short-term interest rates
Forward Rate
� Inferred short-term return for future period that makes expected total return of long-term bond equal to that of rolling over short-term bonds
� Imagine that return of a 30-year bond is equal to 30 rolled over one-year bonds
Liquidity Preference Theory
Investors demand risk premium on long-term bonds
Liquidity premium
Extra expected return demanded by investors as compensation for greater risk of long-term bonds
Capital Asset Pricing Model (CAPM)
Security's required rate of return relates to systematic risk measured by beta (?)
Market Portfolio (M)
Each security held in proportion to market value
Hypothetical Equilibrium
� All investors choose to hold market portfolio
� Market portfolio is on efficient frontier, optimal risky portfolio
hypothetical equilibrium
� Risk premium [?? ???? ? ????] on individual assets
� Proportional to risk premium [?? ???? ? ????] on market portfolio
� Proportional to beta (?) coefficient of security on market portfolio
Risk Premium [?? ???? ? ????] of Market Portfolio
Demand drives prices, lowers expected rate of return/risk premiums
risk-free asset
When premiums fall, investors move funds into
Equilibrium risk premium [?? ???? ? ????] of market portfolio proportional to
� Risk of market
� Risk aversion of average investor
Expected return-beta relationship
Implication of CAPM that security risk premiums [?? ???? ? ????] will be proportional to risk premium on market portfolio and beta
The Security Market Line (SML)
� Represents expected return-beta relationship of CAPM
� Graphs individual asset risk premiums as function of asset risk
Alpha (?)
Abnormal rate of return on security in excess of that predicted by equilibrium model (CAPM)
Applications of CAPM
Use SML as benchmark for fair return on risky asset
0 (Applications of CAPM)
Beta (?) of the risk-free asset =
1 (Applications of CAPM)
Beta (?) of the market portfolio =
greater than ??(??m)
If a stock has Beta (?) > 1, its required return based on CAPM is
less than ??(??m)
If a stock has Beta (?) < 1, its required return based on CAPM is
alpha (?) is positive
An underpriced stock provides an expected return which is greater than the required return based on the capital asset pricing model (CAPM) means
alpha (?) is negative
An overpriced stock provides an expected return which is less than the required return based on the capital asset pricing model (CAPM) means
Random Walk
Notion that stock price changes are random
unpredictable
�Stock prices change in response to "new" information
� "New" information, by definition, is
Efficient Market Hypothesis (EMH)
Prices of securities fully reflect available information
Competition as Source of Efficiency
� Investor competition should imply stock prices reflect available information
� Investors exploit available profit opportunities
Weak-form EMH
Stock prices already reflect all information contained in the history of trading (like past prices, trading volume)
Semi-strong-form EMH
Stock prices already reflect all public information (like financials, company news)
Strong-form EMH
Stock prices already reflect all relevant information, including inside (private) information
Technical Analysis
Research on recurrent/predictable price patterns
technical analysis should be useless
Implication of Weak-form EMH
Fundamental Analysis
�Research on determinants of stock value, i.e. earnings, dividend prospects, future interest rate expectations and firm risk
� Assumes stock price equal to discounted value of expected future cash flow
� Semi-strong-form EMH: Stock prices already reflect
Passive investment strategy
� Buying well-diversified portfolio without attempting to find mispriced securities
� Common strategy for this involves using index funds
Index fund
Portfolio designed to replicate the performance of a broad-based index of stocks
market inefficiency
Active management assumes
Passive management
consistent with semistrong efficiency (stock prices already reflect all public information)
Weak-Form Tests:
-Returns over short horizons
-Patterns in Stock Returns
Momentum effect
Tendency of poorly- or well-performing stocks to continue abnormal performance in following periods
Market Anomalies
Semi-strong From Tests:
Anomalies
Patterns of returns contradicting EMH
Small-firm effect
Stocks of small firms can earn abnormal returns
Book-to-market effect
Shares of high book-to-market firms can generate abnormal returns
Post-earnings announcement price drift
Sluggish response of stock price to firm's earnings announcement
Bubbles and market efficiency
Speculative bubbles can raise prices above intrinsic value
Inside Information
Strong Form Tests:
make superior profits
Insiders can always
non-public
Insider trading is illegal when the material information is still
strong-form efficient
Market is not expected to be
� Returns over short horizons
� Momentum effect
Weak-Form Tests: Patterns in Stock Returns example
� Anomalies
� Small-firm effect
� Book-to-market effect
� Post-earnings announcement price drift
� Bubbles and market efficiency
Semi-strong From Tests: Market Anomalies examples