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# Financial Securities Chap 6, 9 & 10 Test Review.doc

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School
Ryerson University
Department
Finance
Course
FIN 300
Professor
Ron Babin
Semester
Fall

Description
Financial Securities Chap 6, 9, & 10 T est Review Yield (first component of Return): Yield is the income component of a security’s return. The issuer makes this payment in cash to the holder of the asset periodically in return for their investment. Capital Gain/Loss (second component of Return): Capital gain or loss is the depreciation or appreciation in a security’s price over time. It can be measured as the difference between the sale price and the subsequent price, if the difference is negative, then the investor is at a capital loss, if it is positive, then they are at a capital gain. Total Revenue Formula: To calculate total revenue, simply add up all revenue values given. Ex – Revenue for 2003 was \$6000, for 2004 was \$10,000, and for 2005 was \$20,000. What is the total revenue in 2005? Answer – 6000+10,000+20,000=\$36,000 Investing in Bonds & Shares: Bonds have a smaller yield in the short term than shares (stocks) do; however, since the risk in Bonds is very minimal, they typically result in a greater Capital Gain in the long term. The yield of shares (stocks) is determined by the risk level of the investment. Typically, the greater the risk of the investment, the greater the yield. Types of Risk: SR – Systematic Risk – Risk that affects companies on a macro scale 1) Interest Rate Risk (SR) – Variability in the return of a security due to changes in the interest rate 2) Market Risk (SR) – Variability in the return of a security due to fluctuations in the market 3) Inflation Risk (SR) – Variability in the return of a security due to inflation, this is closely tied with the interest rate risk as interest rates typically increase as inflation is occurring 4) Exchange Rate Risk (SR) – Variability in the return of a security due to currency fluctuations, international investors are the most who are affected by this 5) Country Risk (SR) – Variability in the success of companies that deal internationally as a result of political or economic turmoil in the country wherein which the company exists NSR – Non-Systematic Risk – Risk that affects specific & individual companies 1) Business Risk (NSR) – The risk of doing business in only one specific industry 2) Financial Risk (NSR) – The risk in having a company financed mostly by debt, which results in much lower returns (Companies can’t pay shareholders if they can’t pay creditors) 3) Liquidity Risk (NSR) – The risk of company’s inability to be liquid (bought and sold) in the stock market, thus leading to no change in the value of stock Risk Prevention: Risk cannot be prevented, but it can be controlled. Risk control is done through beta calculations, and the CAPM formula. Another way to control risk is to diversify your investments. Total Return: - Total return is the percentage measure relating all cash flows on a security for a given time period to its purchase price - 2 components of TR are yield & price change - If ending price of stock is > beginning price, and dividends are low, TR is negative - TR is calculated with this formula, - Where, TR = Total Return Yield = Dividend paid by company Pe = The most recent price of the stock Pb = The paid price of the stock CAPM: The Capital Asset Pricing Model (CAPM) relates the required rate of return for any security with the market risk for that security as measured by beta. Since CAPM is only an estimation, there are 8 assumptions that are always made when calculating CAPM so as to maintain consistency in results 1) All investors have identical probability distributions for future rates of return 2) All investors have the same one-period time horizon 3) All investors can borrow or lend money at the risk-free rate of return 4) There are no transaction costs 5) There are no personal income taxes 6) There is no inflation 7) No single investor can affect the price of stock through his buying/selling decisions. 8) Capital markets are in equilibrium The formula to calculate CAPM’s required rate of return is as follows: K(i) =RF + B(i) [ E(Rm) –RF] Where, K (i) = required rate of return of investment ‘i’ RF = risk free rate of return B(i) = Beta coefficient of investment ‘i’ E(Rm) = Expected rate of return on the market portfolio Beware that in many cases, the expected rate of return is not given and must be calculated by using this formula (or variations of it based on the data given): E(Rm) = E(Rp) + RF Where, E(Rm) = Expected rate of return on the market portfolio E(Rp) = Equity risk premium RF = Risk free rate This formula makes sense because - E(Rp) is the portion of the CML that is M < Risk < L - RF is the portion of the CML that is RF < Risk < M - E(Rm) is RF < Risk < L Another formula that can be used to calculate E(Rp) is: E(Rp) = TRcs – RF Where, E(Rp) = Equity risk premium TRcs = Total return on common stocks RF = Risk free rate The conclusions of the CAPM are: 1. Return and risk are positively related – greater risk should carry greater return. 2. Investors will only invest if they get a minimum return suggested by CAPM. 3. Each security’s risk will affect the entire portfolio’s risk. Beta: Beta is the measurement of the systematic risk of a security that cannot be avoided through diversification. Typically, the beta of a single security is given; however, to calculate the beta of an entire portfolio, one must use this formula: + + +… Where, - B
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