Financial market quiz, Quizzes of Financial Market

Download Financial market quiz and more Quizzes Financial Market in PDF only on Docsity! Loanable Funds Theory a theory of interest rate determination that views equilibrium interest rates in financial markets as a result of supply and demand for loanable funds. Inflation Determinants of Interest Rates for Individual Securities Real Interest Rates Default or Credit Risk Liquidity Risk Special Provisions or Covenants Term to Maturity Prezi  Supply of Loanable Funds theory  Demand of Loanable Funds theory  Equilibrium Interest Rate Supply of Loanable Funds Theory - is a term commonly used to describe funds provided to the financial markets by net suppliers of funds. In general, he quantity of loananable funds Supply increases as interest arise.Other factors held onstant;more funds are supplied as interest increases(the reward of suppying funds is higher.) Demand of Loanable Funds Theory is a term used to describe the total net demand for funds for fund users. General, the quantity for loanable funds demanded is higher as interest rates fall. Other factors held constant; more funds are demanded as interest rates decrease (the cost of borrowing funds is lower). Equilibrium Interest Rate The aggregate supply of loanable funds in the sum of the quantity supplied by the separate fund, supplying. Similarly, the aggregate demand for loanable funds in the sum of the quantity demanded by the separate fund demanding sectors. As long as competitive forces are allowed to operate freely in financial system, the interest rate that equates the aggregate quantity of loanable funds supplied with aggregate quantity of loanable funds demanded for security,i point E. Factors That Cause the supply and Demand Curves for Loanable Funds to Shift Movement of Interest Rates Over Time The loanable funds theory of interest rates is based on the supply and demand for loanable funds as functions of interest rates. The equilibrium interest rate point is only a temporary equilibrium. Changes in underlying factors that determine the demand and supply of loanable funds can cause continuous shifts in the supply and/or demand curves for Loanable funds. Market forces will react to the resulting disequilibrium with a change in the equilibrium interest rate and quantity of funds traded in the market. Determinants of Interest Rates for Individual Securities  Inflation  Real Interest Rates  Default or Credit Risk  Liquidity Risk  Special Provisions or Covenants  Term to Maturity Inflation - the continual increase in the price level of basket of goods and services – of the general price index of goods and services (IP) is defined as the (percentage) increase in the price of a standardized, basket of goods and services over a given period of time. Specifically, the higher the level of actual or expected inflation, the higher will be the interest rates. The intuition behind the positive relationship between interest rates and inflation rates is that an investor who buys a financial asset must earn a higher interest rate when inflation increases to compensate for the increased cost of forgoing consumption of real, goods and services today and buying these more highly priced goods and services in the future. In other words, the higher the inflation rate, the more expensive the same basket of goods and services will be in the future. A real interest rate - is the interest rate that would exist on a security if no inflation were expected over the holding period (e.g., year) of a security. The real interest rate on an investment is the percentage change in the buving power of a dollar. As such, it measures society's relative time preference for consuming today rather than tomorrow. The higher the society's preference to consume (i.e., the higher its time value of money or rate of time preference), the higher the real interest rate (RIR) will be. Default or Credit Risk - that a security issuer will default on making its promised interest and principal payments to the buyer of security. The higher the default risk, the higher the interest rate will be demanded by the buyer of the security to compensate him or her for this default (or credit) risk exposure. Not all securities exhibits default risk. Liquidity Risk - A highly liquid asset one that can be sold at a predictable price with low transaction costs and thus can be converted into its full market value at short notice. The interest rate on a security reflects its relative liquidity, with highly liquid assets carrying the lowest interest rates. Likewise, if a security is illiquid, investors add a liquidity risk - the risk that a security can be sold at a predictable price with low transaction cost on short notice - premium (LRP) to the interest rate on the security Special Provisions or Covenants - Numerous special provisions or covenants that may be written into the contracts underlying the issuance of security also affect the interest rates on difference securities. Special provisions include the security's taxability, convertibility, and callability. Terms to Maturity - Interest rates are also related to the term to the maturity of a security. This relationship is often called the term structure of interest rates or the yield curve. The term structure of interest rate compares the interest rates in securities, assuming that all characteristics except maturity are the same. The changed in required interest rates as the maturity of a security changes is called the maturity premium (MP). The MP, or the difference between the required yield on a long- and short-term securities of the same characteristics except maturity can be positive, negative, or zero. CHAPTER 3: "INTEREST RATES AND BOND AND SECURITY VALUATION"  Overview of Interest Rates  Term Structure of Interest Rates  Risk Premiums  Bonds Overview  Bond Valuation  Bond Value Behavior OVERVIEW: INTEREST RATES Interest Rate and Required Return represents the cost of money. It is the compensation that a supplier of funds expects and a demander of funds must pay. However, interest rate is applied to debt instruments, such as bank loans or bonds, while required return is applied to equity investments, such as common stock, that gives the investor an ownership stake in the issuer. Note: Factors that affect the equilibrium interest rate: 1. Inflation 2. Risk 3. Liquidity preference The Real Rate of Interest vs. Nominal or Actual Rate of Interest - The real rate of interest is the rate that creates equilibrium between supply of savings and the demand for investment funds in a perfect world, without inflation, where suppliers and demanders of funds have no liquidity preferences and there is no risk. VERSUS - Nominal or actual rate of interest is the actual rate of interest charged by the supplier of funds and paid by the demander of funds. TERM STRUCTURE OF INTEREST RATES - The term structure of interest rates is the relationship between the maturity and the rate of return for bonds with similar level of risk. A graph of this relationship is called "yield curve".  Types of Yield Curves  Theories of Term Structure Types of Yield Curves 1. Yield to Maturity - represents the compound annual rate of return that an investor earns on the bond, assuming that the bond makes all promised payments and the investor holds the bond to maturity. 2. Normal Yield Curve - is an upward-sloping yield curve indicating that the long-term interets rates are generally higher than short-term interest rates. 3. Inverted Yield Curve - is a downward-sloping yield curve indicating that the short-term interest rates are generally higher than short-term interest rates. Theories of Term Structure 1. Expectations Theory - theory that the yield curve reflects investor's expectations about future interest rate; an expectation of rising interest rates results in an upward-sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve. 2. Liquidity preference theory - theory suggesting that long-term rates are generally higher than short-term rates (hence, the yield curve is upward-sloping) because investors perceive short-term investments to be more liquid and less risky than long-term investments. Note: Borrowers must offer higher interest rates on long-term bonds to entice investors away from their preferred short-term securities. 3. Market segmentation theory - theory suggesting that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determines its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment. RISK PREMIUMS - Investors generally demand higher rates of return on risky investments as compared to safe ones. Otherwise, there is little incentive for investors to bear the additional risk. OVERVIEW: BONDS Corporate Bond is a long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. The coupon interest rate on a bond represents the percentage of the bond's par value that will be paid annually, typically in two equal semiannual, payments, as interest.  Legal Aspect of Corporate Bonds  Components of Bond Indentures  Cost of Bonds to the Issuer  General Features of Bond Issue CHAPTER 3 (PART 2): INTEREST RATES AND BOND AND SECURITY VALUATION  Overview of Equity Security  Common and Preferred Stock  Basic Rights of Preferred Stockholders  Features of Preferred Stock  Basic Common Stock Valuation Equation  Other Approaches to Common Stock Valuation Overview: Equity Security Valuation - Equity consists of funds provided by the firm's owners (investors or stockholders) and is repaid subject to the firm's performance. A firm can obtain equity either stockholders, or externally, by selling common or preferred stock. Unlike debt securities, wherein it includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule payments and the relationship of the two parties are as creditor and debtor, the party who buys stocks are called investors/ stockholders. Key Differences between Debt and Equity Common and Preferred Stock Common stock - the true owners of corporate business are the common stockholders. They are sometimes referred to as residual owners because they received what is left after all other claims on the firm's income and assets have been satisfied. Preferred stock - gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount.  Key Words - Common Stock  Types of Common Stock  Types of Preferred Stock TYPES OF COMMON STOCK Privately owned (stock) - The common stock of a firm owned by private investors, this stock is not publicly traded. Publicly owned (stock) - The common stock of a firm is owned by public investors; this stock is publicly traded. Closely owned (stock) - The common stock of a firm is owned by an individual or a small group of investors (such, as a family); these are usually privately owned companies. Widely owned (stock) - The common stock of a firm is owned by many unrelated individual or a small group of investors (such as a family); these are usually privately owned companies. Key Words - Common Stock Par value is an arbitrary value established for legal purposes in the firm's corporate charter and which can be used to find the total number of shares outstanding by dividing it into the book value of common stock. Preemptive rights it allows common stockholders to maintain their proportionate ownership in the corporation, when new shares are issued, thus protecting them from dilution of their ownership. Dilution of ownership is a reduction in each previous shareholder's fractional ownership resulting from the issuance of additional shares of common stock. Dilution of earnings is the reduction in each previous shareholders' fractional claim on the firm's earnings resulting from the issuance of additional shares of common stock. Rights is a financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their number of owned shares. Authorized shares are shares of common stock that a firm's orate charter allows to issue. It is also the number of shares that was registered by the company to the SEC that was allowed to issue. Outstanding shares are issued shares of common stock held by investors, including both private and public investors. Treasury shares are issued shares of common stock held by the firm; often these shares have been repurchased by the firm. Issued shares are shares of common stock that have been put into circulation; the sum of outstanding shares and treasury stock. Voting rights - generally, each share of common stock entitles its holder to one vote in the election of directors and on special issues. Votes are generally assignable and may be cast at the annual stockholders' meeting. Voting, rights and different cases are thoroughly discussed in Corporation Law. Dividends - the payment of dividends to the firm's shareholders is at the discretion of the company's board of directors. Most corporations that pay dividends pay them quarterly. Dividends may be paid in cash, stock, or merchandise. Cash dividends are the most common merchandise dividends the least. Common stockholders are not promised a dividend, but they come to expect certain payments on the basis of the historical dividend, pattern of the firm. Types of Preferred Stock Par-value preferred stock - preferred stock with stated face value that is used with the specified dividend percentage to determine the annual dollar dividend. No-par preferred stock - preferred stock with no stated face value but with a stated annual dollar dividend. Basic Rights of Preferred Stock Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a fixed periodic payment (dividend). However, preferred stock has no maturity date, because they have a fixed claim on the firm's income that takes precedence over the claim of common stockholders, preferred stockholders are exposed to less risk. Preferred stockholders are also given preference over common stockholders in the liquidation of assets in legally bankrupt firm, although they must "stand in line behind creditors. In other words, in the general rule, if liabilities are paid first before the division of equity after paying all the liabilities, the excess will be divided between the stockholders and preferred stockholders are paid first, any excess after paying the preferred stockholders are divided between the common stockholders. Features of Preferred Stock a. Restrictive Covenants - in preferred stock restrictive covenants focus on ensuring the firm's continued existence and regular payment of the dividend. These includes provisions about passing dividends, the sale of senior securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock. The violation of preferred stock covenants usually permits preferred stockholders either to obtain representation on the firm's board of directors or to force the retirement of their stock at or above its par or stated value. b. Cumulation - Most preferred stock is cumulative with respect to any dividends passed. That is, all dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders. Cumulative preferred stock - Preferred stock for which all passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common shareholders. Noncumulative preferred stock - Preferred stock for which passed (unpaid) dividends do not accumulate. c. Other features - Preferred stock can be callable or convertible. Callable preferred stock - allows the issuer to retire the shares within a certain period of time and at a specified price. Convertible preferred stock - allows holders to change each share into a stated number of shares of common stock. Common Stock Valuation Market value - the interactions of may buyers and sellers that result in an equilibrium price. It is the price or value where in the buyers are willing to pay and sellers are willing to pay in a competitive market. Market efficiency - continuous moving toward a new equilibrium that reflects the most recent information available that results in stock price fluctuations.  Free Cash Flow Valuation Model  Zero Growth Model  Constant Growth Model or Gordon Growth Model  Variable Growth Model Zero-Growth Model An approach to dividend valuation that assumes a constant, non-growing dividend stream. In simplest approach, it assumes that the dividend per share to be expected to be received next year (D1) is the same indefinitely. Constant Growth or Gordon Growth Model A widely cited dividend valuation approach that will assumes that dividends will grow at a constant rate, but a rate that is less than the required return. Variable Growth Model - A dividend valuation approach that allows for a change in the dividend growth rate. Free Cash Flow Valuation Model A model that determines the value of an entire company as the present value of its expected free cash flows discounted at the firms weighted average cost of capital, which is its expected average future cost f funds over the long run. Book Value per Share The amount per share of common stock that would be received if all of the firm's assets were sold for their exact book value and the proceeds remaining after paying all liabilities, including preferred stock, were divided among stockholders. Liquidation Value per Share The actual amount per share of common stock that would be received if all of the firm's assets were sold for their market value, liabilities and preferred stock were paid, and any remaining money were divided among the common stockholders. Price/Earnings (P/E) Multiplies Approach A popular technique used to estimate the firm's share value; calculated by multiplying the firm's expected earnings per share (EPS) by the average price/earning ratio for the industry. CHAPTER 5: RISK AND RETURN  Fundamentals of Risk and Return  Risk Preferences  Risk Assessment  Risk Measurement  Risk of a Portfolio RISK AND RETURN: FUNDAMENTALS Each financial decision presents certain risk and return characteristics, and the combination of these characteristics can increase or decrease a firm's share price. Analysts use different methods to quantify risk, depending on whether they are looking at a single asset or portfolio collection, or group, of assets. Risk is a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset. Return Total rate of return is the total gain or loss experienced on an investment over a given period of time. It is calculated by dividing the asset's cash distributions during the period, plus change in value, by its beginning- of-period investment value. RISK AVERSE The attitude toward risk in which investors would require an increased return as compensation for an increase in risk. RISK SEEKING The attitude toward risk in which investors which investors prefers investments with greater risk even if they have lower expected returns. RISK NEUTRAL The attitude toward risk in. which investors choo s investment with the hig' return regardless of its risk. RISK ASSESSMENT - The notion that risks is somehow connected - to uncertainty is intuitive. The more uncertain an investment will perform, the riskier that investment seems. Scenario analysis provides a simple way to quantify that intuition, and probability distributions offer an even more sophisticated way to analyze the risk of an investment.  Scenario Analysis  Probability Distribution SCENARIO ANALYSIS An approach for assessing risk that uses several possible alternative outcomes to obtain a sense of variability among returns. One common method involves considering, pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the returns associated with them for a given asset. In this one measure of an investment's risk is the range of possible outcomes. The range is found by subtracting the return associated with the pessimistic outcome from the return associated with the optimistic outcome. The greater the range, the more variability, or risk, the asset is said, to have. PROBABILITY DISTRIBUTION The probability of a given outcome is the chance of occurring. An outcome with an 80% probability of occurrence would be expected to occur 8 out of 10 times. An outcome with probability of 100% is certain to occur. Outcomes with a probability of zero will never occur. The probability distribution is a model that relates probabilities to the associated outcomes. Most investments have more, than two or three possible outcomes. In fact, the number of possible outcomes in most cases is practically infinite. If we knew all the possible outcomes and associated possibilities, we could deve Prezi nuous probability distribution. Continuous probability distribution - A probability distribution showing all the possible outcomes and associated probabilities for a given event. 1. STANDARD DEVIATION - measures the dispersion of an investment's return around the expected return. The expected return is the average return that an investment is expected to produce overtime. 2 NORMAL DISTRIBUTION - A normal probability distribution, depicted resembles a symmetrical "bell- shaped” curve. The symmetry of the curve means that half the probability is associated with the values to the left of the peak and half with the values to the right. Coefficient of Variation - Trading off Risk and Return A measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns. Prezi RISK OF A PORTFOLIO The financial manager's goal is to create an efficient portfolio, one that provides the maximum return for a given level of risk. We therefore need a way to measure the return and the standard deviation of a portfolio of assets. As part of that analysis, we will look at the statistical concept of correlation, which underlies the process of diversification that used to develop an efficient portfolio.  Portfolio return and Standard deviation  Correlation  Diversification CORRELATION Correlation is a statistical measure of the relationship between any two series of numbers. The numbers may represent data of any kind, from returns to test scores. Positively correlated - Describes two series that move in the same direction.