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# 2557A/B- Midterm Exam Guide - Comprehensive Notes for the exam ( 36 pages long!)

Department
Financial Modelling
Course Code
FM 2557A/B
Professor
Xiaoming Liu
Study Guide
Midterm

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Western
Financial Modelling 2557A/B
MIDTERM EXAM
STUDY GUIDE

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Security: A document that confers upon its owner a financial claim
3 categories of securities:
1. Debt Securities - bonds, bank notes, etc.
2. Equity Securities - common stock
3. Derivative Contracts - forwards, futures, options, and swaps
Bond: A document that gives its owner the right to a fixed, predetermined payment at the maturity date
Nominal Value/Face Value/Par Value/Principal: Amount of payment at maturity
Specifics of bond are timing, amount, paying/receiving, counterparties
Coupon Bonds: Bonds for which the debtor makes periodic payments to the creditor
Period payments = coupons
At maturity, last coupon and nominal value is paid
Zero-coupon bonds: Pure discount bonds
Equivalent to basket of pure discount bonds with nominal values = coupons
oIf bond price = nominal value, at par
oIf bond price > nominal value, above par
oIf bond price < nominal value, below par
1. Delay purchase power or spending
oSave for retirement
oCover future liabilities - like insurance claism
oThrough mortgages, car loans, credit card purchases
oCorporations borrow regularly to finance business opportunities
Bonds issued by corporation are called deb
oGovernments and other entities issue bonds to fund public work projects
Stock: Gives owner right to a proportion of profits distributed, and a part of the firm in case of
liquidation
Owner = stockholder
Stock dividends are profits the firm distributes to the stockholders
Random
Depend on firm's profit and policy
Dividend yield = ratio of annual dividends per share over the stock price per share
1. Make money by investing in companies you believe will make money
oSeeking a positive return
1. Dividend received while owning the stock
2. Capital gain/loss = purchase price - selling price
Stocks Bonds
Random Dividend Predetermined Coupon
No Guaranteed Nominal Value Guaranteed Nominal Value
No Expiry Contract Maturiy
More Price Volatility Less price Volatility
Higher Return Lower Return
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Dividend Taxation Coupon taxation
Less Affected by Inflation More Affected by Inflation
Derivatives: Financial instruments whose payoff depends on the value of another variable called the
underlyig asset
Provide protection against uncertainty
Why use derivatives?
1. Risk Management
2. Speculation
3. Reduce Transaction Costs
4. Regulatory Arbitrage
Market Index: Weighted average value of a number of instruments that trade in that market
Provide summary measure of how particular market performs
Most financial claims are traded on exchanges
Exchange: Organization that provides a venue for trading and sets rules governing what is traded and
Organized market
Over the Counter: Trade financial claims directly with a dealer bypassing organized exchanges
Hard to observe
Usually higher value of trade higher than exchange
3 Perspectives on Derivatives:
1. End Users = Corporations, Investment managers, Investors
2. Intermediaries = Market makers, Traders
3. Economic Observers = Regulators, Researchers
The role of the financial market is to make risk sharing more efficient
Diversifiable risk vanish
Non-diversifiable risks are reallocated to those most willing to hold it
Risk in Bonds
1. Credit Risk/Default Risk: Risk to creditor that the debtor will be unable to make the
promised payments
2. Inflation Risk: Future prices of goods is uncertain - in the future, one cannot be certain
how much one dollar will buy
oReal-return bonds or inflation-indexed bonds have payments that depend on the
amount of inflation
3. Liquidity Risk: The risk of having to sell at a given time at low prices, possibly due to low
interest
4. Market Risk: Possible low price since the price of the bond depends on the level of
interest rates or term structure prevailing at given time
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