[FIN 332] - Midterm Exam Guide - Ultimate 13 pages long Study Guide!

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7 Feb 2017
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Western Kentucky University
FIN 332
MIDTERM EXAM
STUDY GUIDE
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Investment- shifting current consumption (spending) for the exchange of future benefits and
consumption- not spending $ now to spend in the future
Consumption: buying food, clothes, partying
Investment: put money in
Savings accounts (purchasing power decreases every year because the interest rate < rate of
inflation)
Money market- no time restriction on withdrawals
Certificate of Deposit- can only take money out after x amount of time
Pays a higher interest rate because it is inflexible
Buy stocks or bonds or real assets (real estate)
Real assets- assets used to produce goods or services in the economy that make money
Tangible- equipment; what you can touch
Intangible- intellectual property
Financial assets- claims on real assets or earnings produced by real assets
Stocks and bonds traded in the primary market
Doesn’t directly produce $ but gives you a claim to get $ from the real assets
Positive net present value
Businesses raise $ in the primary market
Issue stock- take shareholder $ and invest it in real assets to give an investor a claim on
real earnings (dividends) for stock and coupon payments for bonds
Risk-Return Tradeoff: in a relatively efficient market, assets are priced at the fair market value most of
the time, therefore riskier investments must pay higher average returns than safer investments
The star is the risk free rate or the rate of return earned on zero
risk. This is T-Bills, which are short term debt issued by the
federal government with zero risk
In a perfectly efficient market, all assets would be located on the
line
However, if there was an asset above the line (A) that had the same level of risk as an asset on the line (B)
the demand for A would increase. But as the demand increase, the demand curve shifts to the right, and
the price of A increases, which decreases the return on A (PV = FV / (1+r)^t)
As r increases, the PV decreases- when price increase, the return decreases
Total risk = systematic risk + unsystematic risk
Systematic risk cannot be eliminated through diversification
Most investors are risk averse
Tota risk is measured by the standard deviation of the asset
More volatility = higher uncertainty = higher risk
Short run- high risk can give you a low return when it does really
bad but in the long run, the high returns outweigh that
Major classes of financial assets or securities- debt, preferred stock, common stock, derivative securities
Debt/Fixed Income
Bonds- > 10 years original maturity
Return
Risk
systematic
unsystematic
Total
Risk
# of assets
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Notes- between 1 and 10 years original maturity
Money market instruments- original maturity of less than one year
Choose when you think you can return the money to investors
Pay coupon payments semi-annually (except money markets)
Bonds and notes are traded in the capital market, where long term assets (>1 yr)
Orginail maturity- measured from time bond is issued until it matures
Time to maturity- measured from now to maturity
20 year bond 5 years ago 20 original; 15 time to- return par value back
When bonds are first issued, the coupon rate is generally equal to the yield to maturity
This means that the price is equal to the par value ($1,000)
When the coupon rate is less than the yield to maturity, the price is less than the par value- discount
There is a negative relationship b/t price and return
So when the return is higher (YTM increases) the price decreases
When the coupon rate is more than the yield to maturity, the price is more than the par value- premium
There is a negative relationship b/t price and return
So when the return is lower (YTM < coupon) the price is higher to compensate
T-bills do not make coupon payments because they are short-term
Gov would issue T-bonds and T-notes for the long term
T bills are always traded at a discount because the coupon rate (0%) is less than YTM
Because the YTM is higher than the coupon, the higher return = lower price
The coupon rate is fixed for the life of the bond
The yield to maturity/discount rate can change when the risk level changes
Pb = c[(1-1/(1+r)^t) / r] + [FV / (1+r)^t]
Price of bond = present value of coupon payments + present value of par
So the price of t-bills, because they don’t have coupon payments = FV / (1+r)^t = discount
On maturity date, the price of bond is equal to the par value + the last coupon payment
Bond ratings are used to measure default risk
The higher the default risk, the lower the bonds rating
SP = AAA, AA, A, BBB = investment grade
BB, B, CCC, CC, c, D = low quality/junk bond
Moody’s = Aaa, Aa, A, Baa = investment grade
Ba, B, Caa, Ca, C, D = low quality/junk bond
So the rate of return, or YTM of AAA < the YTM of D because D is riskier
Preferred sotck
Get dividend payment before stockholders
No voting rights
Fixed dividends
Deferrable- company can push off payments until the next year
Cumulative- get all back payments before stockholders get paid
Less Risk
Bonds- first to get paid; creditors; get paid in form of interest- more likely they get paid
Preferred- cannot vote
Common- owners in the company; residual claim- what’s left over
Lots of price volatility- more uncertainty in the stock price
More Risk
Dividend payments are taxed as ordinary income
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