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by: Bernhard Collier


Bernhard Collier
GPA 3.64

Heidi Toprac

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Heidi Toprac
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This 16 page Class Notes was uploaded by Bernhard Collier on Sunday September 6, 2015. The Class Notes belongs to FIN 320F at University of Texas at Austin taught by Heidi Toprac in Fall. Since its upload, it has received 28 views. For similar materials see /class/181405/fin-320f-university-of-texas-at-austin in Finance at University of Texas at Austin.




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Date Created: 09/06/15
Ch 6 p 9198 Vocabulary Debt a loan to a firm government or individual Discounted securities securities selling for less than par value Repurchase agreement an arrangement where one rm sells some of its nancial assets to another rm with a promise to repurchase the securities at a later date Federal funds overnight loans from one bank to another Banker s acceptance an instrument issued by a bank that obligates the bank to pay a speci ed amount at some future date Commercial paper a discounted instrument that is a type of promissory note or legal IOU issued by large nancially sound rms Certificate of deposit an interestearning time deposit at a bank or other nancial intermediary Eurodollar deposit a deposit in a foreign bank that is denominated in U S dollars Money market mutual funds pools of funds managed by investment companies that are primarily invested in shortterm nancial assets Term loan a loan generally obtained from a bank or insurance company on which the borrower agrees to make a series of payments consisting of interest and principal Bond a long term debt instrument Coupon rate interest paid on a bond or other debt instrument stated as a percentage of its face maturity value Government bonds debt issued by a federal state or local government Municipal bonds bonds issued by a state or local government C01porate bonds longterm debt instruments issued by corporations Mortgage bond a bond backed by tangible assets Firstmortgage bonds are senior in priority to secondmortgage bonds Debenture a longterm that is not secured by a mortgage on speci c property Subordinated debenture a bond which in the event of liquidation has a claim on assets only after the senior debt has been paid off Income bond a bond that pays interest to the holder only if the interest is earned by the rm Putable bond a bond that can be redeemed at the bondholder s option when certain circumstances exist Indexed purchasingpower bond a bond that has interest payments based on an in ation index to protect the holder from loss of purchasing power Floating rate bond 7 a bond whose interest rate uctuates with shits in the general level of interest rates Zero coupon bond 7 a bond that pays no annual interest but sells at a discount below par thus providing compensation to investors in the form of capital appreciation Notes Junk bond 7 a highrisk highyield bond used to nance mergers leveraged buyouts and troubled companies Indenture 7 a formal agreement contract between the issuer of a bond and the bondholders Call provision 7 a provision in a bond contract that gives the issuer the right to redeem the bonds under speci ed terms prior to the normal maturity date Sinking fund 7 a required annual payment designed to amortize a bond issue Conversion feature 7 permits bondholders to exchange their investments for a fixed number of shares of common stock Foreign debt 7 debt sold by a foreign borrower buy denominated in the currency of the country where it is sold Eurodebt 7 debt sold in a country other than the one in whose currency the debt is denominated LIBOR 7the London Interbank Offered Rate the interest rate offered by the best London banks on deposits of other large very creditworthy banks Debt Characteristics 0 Usually identify debt by three features principal amount that need to be repaid the interest payments and the time to maturity 0 Principal value of debt is the amount owed to the lender I Usually paid at the maturity date I Also called maturity value face value par value 0 Interest payments are percentages of the principal amount I Some debt doesn t have interest so must be sold for less than pay values 7 called discounted securities 0 Maturity date is the date on which the principal amount is due I Some debt instruments called instrument loans require periodic payments of part of the principal 0 Corporate debt holders have priority over stockholders with regard to distributions of earnings and liquidation of assets so they must be paid first Types of Debt 0 Short Term Debt is debt with a maturity date of a year or less Treasury Bills Tbills are discounted securities issued by the gov t to finance operations and programs Prices are determined by an auction process Repurchase agreement repo is where one company that needs money sells some of its financial assets to another firm which has excess funds to invest with the first company promising to repurchase the securities at a higher price at a later date Most maturity dates for these are overnight Federal funds are loans from one bank to another usually to adjust reserves Thefederalfunds rate is the interest rate associated with this kind of debt Banker s acceptance is a time draft which is an instrument issued by a bank that obligates it to pay a specified amount to the holder of the draft at some future date Commercial paper is a type of promissory work which is issued at a discount and doesn t pay interest the maturity on commercial paper varies from one to nine months with an average of about five months Usually issued in denominations of 100000 or more so often sold to other businesses Certi cates of deposit are a time deposit at a bank or other financial intermediary 0 Traditional CDs generally earn periodic interest and must be kept at the issuing institution for a specified time period To liquidate before maturity the owner must return it to the issuing institution which usually applies an interest penalty to the amount paid out 0 Negotiable CDs can be traded to other investors prior to maturity because they can be redeemed by whoever owns them These are usually issued in denominations of 1 million to 5 million and have maturities that range from a few months to a few years Eurodollar deposit is a deposit in a bank outside the US that is denominated in US dollars which does not expose it to exchange rate risk the risk associated with converting dollars into foreign currencies Not subject to same regulations as deposits in US banks so a higher rate can be earned Money market mutual funds are investment funds pooled and managed by firms who invest money for others for the purpose ofinvesting in shortterm financial assets 0 Long term debt Maturities greater than one year Term loans are contracts under which a borrower agrees to make a series of interest and principal payments to the lender on speci c dates Maturities range from 2 to 30 years Have three advantages of public debt offerings speed exibility and low issuance cost Bonds are long term contracts under which a borrowerissuer agrees to make payments of interst and principal on speci c dates to the bondholderinvestor The interest payments are determined by the coupon rate which represents the total interest paid each year as a percentage of the bond s face value Interest is usually paid semiannually principal usually paid at maturity o 1 Government bonds issued by USstatelocal gov ts US gov t bond are issued by the Treasury and are called either Treasury notes or Treasury bonds Both pay interest semiannually T notes maturity can be 1 to 10 years T bonds maturity exceeds 10 years 0 Municipal bonds issued by state local gov ts 0 General obligation bonds are backed by the gov t ability to taX its citizens special taxes or taX increases are used to generate the funds needed to service these bonds 0 Revenue bonds are used to raise funds for projects that will generate revenues that contribute to payment ofinterest and the repayments of the debt 2 Corporate bonds sold by corporations issue is advertised and offered to the public sold to many different investors Usually fixed interest rates 3 Mortgage bond corp oration pledges tangible assets as collateral for the bond Can have first and second mortgage bonds involves seniority of debt first is senior 4 Debenture is an unsecured bond that provides no claim against specific property as collateral So debenture holders are general creditors whose claims are protected by property not otherwise pledged as collateral o Subordinated debenture is unsecured bond that is inferior to other debt with respect to claims on cash distributions by the firm 5 Other types of corporate bonds 0 Income bonds pay interest only if the firm makes enough income to pay so these are riskier bonds Putable bonds can be turned into cash at the bondholder s option if the firm doe some specific action stated in a contract Indexedpurchasing power bonds pay interest based on an in ation index interest rises when in ation rises o Floating rate bonds coupon rates quot oatquot with market interest rates often have caps limits set on how high and low the rates can go 6 Original issue bondszero coupon bonds are securities offered at discounts because they pay no interest The annual prorated capital appreciation that would be received if the bond were held to maturity is TAXABLE even before the money has been received So usually individual investors don t hold these 7 Junk bonds are highrisk high yield bonds often issued to finance a management buyout a merger or a O O troubled company Bondholders must bear as much risk as stockholders normally would 0 Bond contract features 0 Bond indentures are documents that spell out the legalities of the bond issue including the rights of the bondholders and the issuer A trustee usually a bank is assigned to represent the bondholders Includes restrictive covenants which includes bond issuance restrictions and conditions of payment SEC approves indentures for publicly traded bonds Call provisions give the issuing firm the right to quotcallquot the bonds for redemption prior to maturity A call premium is often put in place which typically equals one year s interest if the bond is called during the first year in which a call is permitted with a declining rate thereafter Bonds usually have deferred calls and must be called after a certain number of years These are said to have call protection Sinking fund is a provision that allows the bond to be retired partially each year it require the firm to retire a portion of the bond issue each year Can happen two ways I By randomly calling for redemption t par value a certain percentage of bonds I By purchasing the required amount of bonds in the open market 0 Conversion feature allows the bondholder to exchange convert the bond into shares of common stock at a fixed price The conversion ratio is the number of shares of stock the bondholder receives upon conversion The conversion price is the price that is quotpaidquot for the common stock by converting a bond into stock A 1000 bond with a CR of 20 can be converted into 20 shares of stock so CP is 100020 50 0 Foreign Debt Instruments 0 Foreign debt is debt sold b a foreign borrower but is denominated in the currency of the country in which it will be sold Foreign bonds issued in the US are called yankee bonds Eurodebt is any debt sold in a country other than the one in whose currency it is denominated Includes Eurobonds I Interest rates on shortterm Eurodebt typically are tired to a standared rate LIBOR 0 Bond Ratings 0 Two major rating agencies Moody s and SampP 0 Rating Criteria I Qualitative financial strength of the company collateral provisions seniority of debt etc I Quantitative factors I No precise formula 0 Bond ratings are important because they indicate default risk and many institutions are restricted to investment grade securities 0 O O 0 Ratings can change base don a change in the issuer s nancial circumstances FIN 320F Foundations of Finance Chapter 6 Debt Section 1 Review 1 A nancial instrument is a particular type of debt or equity that a company issues to the public to raise money There are three basic types of nancial instruments a Debt is borrowed money that must be repaid iii a lt v39 S viii The principal is the amount that must be repaid by the end of the term The principal is also called the maturity value par value and or face value The interest rate is the borrower s cost of the debt With bonds the interest rate is called the coupon rate With Tbills the interest rate is called the discount rate The maturity date is when the principal must be repaid The interest payment INT equals the par value of the bond M times the annual coupon rate C then divided by the number of payments per year m INT M x C m Most coupon interest payments are paid semiannually thus m is usually 2 In the event of liquidation debtholders have priority over equity investors Employers and customers are paid rst followed by the government debtholders aka creditors and equityholders Debt holders do not have voting rights but can exert some in uence through bond indentures or loan contracts Federal government debt includes US Treasury bills bonds and notes These are considered to be defaultfree instruments since the federal government hasn t ever defaulted on its debt we assume it never will State and local government debt includes revenuegenerating municipal bonds and general obligation municipal bonds both are called munis Revenue generating bonds are repaid with revenue generated by the project that the bond nanced general obligation bonds are repaid with property tax dollars Corporate debt includes commercial paper term loans junk bonds and investment grade bonds When companies take out loans a private placement of debt they need only work with one or two banks to get the money It s a relatively fast and exible process When companies issue bonds a public issue of debt they need to work through an investment banker and borrow funds from potentially thousands of investors The process is much more expensive and time consumingibut also makes it possible to borrow a lot more money 1 A bond indenture is the contract between the buyer and seller or lender and borrower The indenture speci es restrictive covenants that constrain the actions of the borrower such as call provisions and sinking fund requirements a A call provision allows the bond issuer to call pay off the bond before the maturity date Companies would be motivated to do this if interest rates have fallen because they would prefer to issue new debt at the new lower rate reference Dr Pepper Snapple Call provisions generally increase the cost of the debt because they add to investors risk b A sinking fund requires the bond issuer to pay off the debt over BVchXSHKSGdocx Page 1 FIN 320F Foundations of Finance X xi Section 1 Review the course of time rather than paying off the entire amount on the maturity date A sinking fund provision generally decreases the cost of the debt because it decreases the perceived risk 2 A debenture bond has no collateral backing it up whereas a mortgage bond is secured by some form of collateral This makes the cost of mortgage bonds lower than the cost of debenture bonds To subordinate a debt means to make it less important than other debts Subordinated debt gets paid after superior debt therefore subordinated debt is more risky than superior debt There are three ratings agencies Moody s Standard amp Poor s and Fitch that rate corporate debt on a scale from AAA to D The higher the rating the less risky it is therefore the less costly it is to issue Junk bonds are bonds issued by companies with low debt ratings a C for example The low debt rating means the risk of default is high thus junk bonds pay higher than average coupon rates There are three forms of bankruptcy 1 Chapter 7 When a company les for chapter 7 bankruptcy they are declaring themselves insolvent The assets get liquidated turned into cash and the proceeds are A a in my J government and maybe the lenders There will not be anything left for the owners Chapter 11 When a company les for chapter 11 bankruptcy they are said to be restructuring their debts That means the company is negotiating new payment terms with their lenders Sometimes the lenders agree to forgive some of the debts in exchange for ownership of the company reference Six Flags In that case the former equity holders end up with nothing 3 Chapter 13 is when individuals renegotiate their debts E I N Chapter 7 Equity b Both common stock and preferred stock are equity instruments i b l ii39 Common stock represents ownership Ifyou own a share of stock you own a piece of the company Common stock never matures and may or may not pay dividends Stockholders usually have voting rights but get paid last in the event that the company is liquidated Companies send out proxy ballots to stockholders and ask for the right to vote on stockholders behalf Advantages of common stock over debt for the issuer 1 Common stock doesn t require the company to make fixed payments 2 Common stock never matures and never has to be repaid 3 Using common stock improves the company s debt ratio Disadvantages of common stock over debt for the issuer l The company may have to give up some voting control a Founders shares generally have sole voting rights but zero dividends for several years to limit this disadvantage BVchXSHKSGdocx Page 2 FIN 320F Foundations of Finance Section 1 Review b Shares issued to the public nonfounders could be given some other classi cation eg Class B that would limit voting rights but allow for dividend payments 2 If the company chooses to pay a dividend to owners it results in a drain on the company s cash The cost to issue common stock is higher than the cost to issue debt Investment bankers charge higher fees for issuing stock versus debt because of the greater risk that the stock issue will fail 4 Common stock dividend payments are not a taxdeductible expense but interest expense is iv Preferred stock is sort of a cross between common stock and bonds Preferred stock represents ownership and pays dividends which makes it feel like common stock but it has priority over common stock in the event of liquidation and the dividends are of a xed amount which makes it feel like bonds c Derivatives are nancial instruments whose value is based on the value of some other underlying nancial asset The most widely known derivative is a stock option Its value is based on the values of the stocks mentioned in the option grant Most investors are riskaverse This means that most investors expect a higher level of return in exchange for taking on a higher level of risk As a result as the risk of various nancial instruments rises so to do their returns Thus is born the risk return tradeoff Shortterm US Treasuries Tbills represent the lowest risk and return Treasury bonds are a little higher followed by corporate bonds of similar term Within the corporate bond category mortgage bonds are lower risk and debenture bonds are higher risk Preferred stocks have a higher risk and return than bonds and common stocks have a still higher risk and return E N Chapter 3 The Financial Environment 1 Financial markets are where saverslendersinvestors give up their money in exchange for the securities that is the nancial instruments of spendersborrowers companies There are many types of nancial markets a Stocks are traded in equity markets also called stock markets bonds loans commercial paper US Treasuries and other debt instruments are traded in debt markets i Stock markets take several forms 1 The biggest stock market in the US is the New York Stock Exchange NYSE It is an organized physical exchange that is a real physical place located on Wall Street in New York City 2 The NASDAQ is an organized virtual exchange It is a collection of dealers and brokers who are connected electronically via telephones and computers 3 An overthecounter OTC stock market market yes exchange no requires dealers to negotiate directly with one another to trade stocks The stocks traded in OTC markets such as The Pink Sheets are either penny stocks or stock of companies that have poor credit ratings ii Trading in securities is facilitated by brokers and dealers BVchXSHKSGdocx Page 3 FIN 320F Foundations of Finance Section 1 Review 1 Dealers buy inventory then resell it They make their money on the spread that is the difference between the purchase price and the sale price Think car dealers Brokers match up buyers and sellers and earn commissions on the resulting transactions Think ebay b Securities with maturities of more than a year stocks and medium to longterm debt instruments are traded in capital markets securities that mature in a year or less shortterm debt instruments are traded in money markets Since there s no such thing as a shortterm equity instrument it follows that only debt instruments are traded in the money market The rst time an issue of stocks or bonds is offered to the public it is offered in the primary market The stocks or bonds end up in the hands of the public and the cash ends up in the hands of the issuing company i For example if IBM which has many stocks and bonds already outstanding issues a M offer of stocks to the public in order to raise rm money the stocks are offered in the primary market The public gets the stocks and IBM gets the money This is called a seasoned offering because IBM had its initial public offering long ago If a company is offering shares of stock to the public for the rst time in its history we say the company is going public or participating in an initial public offering IPO Again the public gets the stock and the company gets the money Note before the company goes public we say it is private or closely held When the initial buyers of stocks or bonds decide to sell their investments to other members of the investing public the transactions take place in the secondary markets The initial investors give up their stocks or bonds in exchange for cash and the secondary investors give up their cash in exchange for the stocks or bonds None of the money goes to the company that originally issued the stock or bond Nearly all stock transactions are secondary market transactions 2 If markets are perfectly efficient it would be impossible to earn abnormal returns This is a subject of great debate Following the Great Recession nancial and economic researchers are changing their views of what efficiency in a nancial market might mean 3 The Securities and Exchange Commission SEC was created after the Great Depression by Franklin Delano Roosevelt Teddy s nephew to regulate the issuing and trading of nancial securities a All public companies must disclose their nancial information to the investing public You can look up all public nancial information on the SEC s database called EDGAR We ll do this in Section 2 of the course Corporate insiders cannot pro t at the expense of other stockholders That is if you have information that the public doesn t know about you cannot buy or sell the company s stock based on that information It is illegal to arti cially manipulate stock prices An example of such manipulation posting phony press releases on the intemet in the hopes that it will make a company s stock price rise or fall A new rule called the trade through rule has given rise to greater competition among stock markets The rule requires that market orders to buy or sell stocks must N O 3 1 Fquot 0 3 1 BVchXSHKSGdocx Page 4 FIN 320F Foundations of Finance Section 1 Review be executed at the best price available across all of the stock markets rather than at the best price on the market that initially received the order 4 Money is transferred from those who have money to those who need money through one of three primary methods a Via a direct transfer In this case the money goes directly to the company that issues the security and the security goes directly to the investor A private placement of equity and a loan from a bank are both examples of direct transfer Fquot sense Through an investment banker Investment bankers are not bankers in the traditional They don t accept deposits or make loans Instead investment bankers help companies issue new securities to the public 1 Once the company has decided how much money it needs the investment banker helps the company decide what kind of securities to issue how many to issue and at what price Investment bankers may underwrite an issue in which case the investment banker agrees to buy all of the securities and resell them in the primary market This is good for the issuing company because it is assured that all of the shares will be sold at the offer price thus all of the funds it needs will be raised This can also be good for the investment banker if they are able to resell the shares for a profit In that case the investment banker would earn the spread between the offer price and the ultimate purchase price plus their commission Conversely investment bankers might work on a bestefforts basis in which they do not buy the securities directly but merely assist in their sale to the public And earn a commission in the process The issuing company may not get all the money it needs but if they re a small unknown firm this may be the best arrangement they can find c Through a financial intermediary Financial intermediaries facilitate the transfer of funds between those who have money and those who need money There are several iii 2 lt v39 Commercial banks Credit unions Savings amp Loan institutions SampLs and Thrifts all accept deposits from savers They reserve some of the deposits as mandated by the Fed see below to ensure that there is enough cash available for people who want to make withdrawals Then they lend the rest of the money to businesses and individuals When someone says bank they are referring to a commercial bank When the bank lends money it is creating liquidity in the economy In this sense it is creating money Pension funds including Social Security accept contributions from my J and quot mp1 J They invest these contributions then pay out pensions for the employees when the employees retire Only 29 of US companies have pension funds Most of those pension funds are offered only to current employees Most new employees will not have pensions Insurance companies accept premiums from the insured invest the proceeds and hopefully earn enough money to pay out payments for claims of loss Mutual funds are investment companies that pool the resources of many investors in order to buy stocks andor bonds of other companies The mutual fund issues shares of itself to its investors based on the fund s Net Asset Value NAV per share We ll discuss mutual funds in detail during the 43911 section of the course BVchXSHKSGdocx Page 5 FIN 320F Foundations of Finance Section 1 Review 5 The Federal Reserve System the Fed is the central bank of the US It is responsible for regulating banks SampLs and other depository institutions clearing all of the paper checks and electronic payments in the US so that the monies get where they re supposed to go holding the US Treasury s checking account and most importantly conducting monetary policy Conducting monetary policy means controlling the US money supply The Fed is charged with controlling the money supply in order to 1 limit in ation and 2 promote economic growth The problem is these two goals con ict with one another Since in ation and GDP move together lowering one also lowers the other The Fed has several tools a Setting bank reserve requirements This is the percentage of deposits that banks must hold in reserve to ensure there is cash available for those who want to make withdrawals Once banks have met the reserve requirement they can lend out the rest of their deposits If the Fed decreases the reserve requirement banks can lend more money so the money supply increases Currently the reserve requirement is 10 Setting the discount rate This is the rate at which the Fed lends money to banks If the Fed decreases the discount rate banks borrow more money from the Fed which means the banks can lend more so the money supply increases See how the banks just created money The Fed s discount rate is currently 075 Don t confuse the Fed s discount rate with the Federal Funds Rate The latter is the rate at which banks lend money to one another The Federal Funds Rate is currently 025 The Fed sets target for the Federal Funds Rate currently the target is between 0 and 025 then in uences banks to achieve that target by Conducting open market operations The Fed can buy or sell Treasury securities to change the money supply If the Fed buys Treasuries from investors the investors receive the proceeds and put the money in their bank accounts Thus the money supply increases and in ation and GDP both increase If the Fed sells Treasuries investors take their money out of their bank accounts and lend it to the Fed As a result the money supply decreases and in ation and GDP both decrease During the recent recession the Fed was granted a new bag of tricks not only did it expand its lending to investment banks commercial banks insurance companies and automobile manufacturers it accepted toxic assets and equity as collateral That s how the US government ended up owning General Motors Fquot 0 2 1 Chapter 5 Interest Rates 1 Where do interest rates come from a To gure out where market rates come from start with the real riskfree rate r This is the rate that would be paid on nancial instruments that have absolutely no risk whatsoever We assume that the rate on 30day Treasury bills minus in ation equals r This rate is determined by i The Federal Reserve s monetary policy see details above ii The US govemment s foreign trade surplusde cit l The foreign trade balance is the sum of all of the goods and services the US exports to other nations minus the sum of all the goods and services the US imports from other nations exports minus imports For Jan to Nov 2010 we had a foreign trade de cit of 459B Our top trading partners last year were China Mexico Japan Germany N BVchXSHKSGdocx Page 6 FIN 320F Foundations of Finance iii 1 Section 1 Review Ireland Nigeria and Canada In 2004 for the rst time in American history we became net importers of food In other words we longer produce enough or perhaps the right kind of food to feed ourselves 3 Foreign trade de cits put upward pressure on interest rates The US govemment s budget surplusde cit The federal budget balance is the difference between the monies that the government receives in a single scal year mainly in the form of taxes and the amount the government spends in that same year In short it s receipts minus outlays a 09quot 3 1 D According to the Congressional Budget Office for scal 2000 we experienced a budget surplus of 236 billion So it really can happen For scal 2010 we incurred a budget de cit of 13 trillion When a budget de cit exists we spent more than we earned the government has to borrow money to make up the difference This creates debt The nation s debt as of Jan 27 2011 stood at 14 trillion That s about 45000 per US resident children and homeless people included The government must pay interest on their debt In 2010 we paid 428 billion in interest on the federal debt Thus we spent 11 of every tax dollar on interest expense To compare we spent 20 on defense 21 on Medicare and Medicaid 17 on Social Security 30 on everything else Everything else includes all discretionary spending by the departments of agriculture commerce education energy health amp human services housing amp urban development interior justice labor state amp international assistance transportation treasury Corps of Engineers Environmental Protection Agency NASA the National Science Foundation and all other agencies Just think what we could do if we didn t have to pay interest The biggest lender to the US government is the US government 36 of federal debt is owned by US government agencies primarily the Social Security Administration The US public both individual and institutional investors owns 35 of the debt The remaining 29 of US Treasuries are owned by foreign governments companies and individuals China holds 6 Japan 6 UK 2 etc 2 Federal budget de cits put upward pressure on interest rates iv General economic conditions Gross Domestic Product GDP measures all the goods and services produced within the country s borders Gross National Product GNP measures all the goods and services produced by a country regardless of where the actual production takes place If GDP is rising we say the country s economy is expanding if GDP is falling the economy is contracting 2009 real GDP that is GDP without 1 BVchXSHKSGdocx Page 7 FIN 320F Foundations of Finance Section 1 Review in ation fell by 26 So our economy shrankithat s what we mean by a recession 2010 real GDP rose 29 2 During periods of economic expansion booms there is greater demand for money putting upward pressure on interest rates 3 During periods of economic contraction recessions or busts there is less demand for money putting downward pressure on interest rates b Okayia shift in the discussion After guring out the real riskfree interest rate r based on the above discussion we add in a premium to compensate for the cost of in ation IP and this Will give us the nominal riskfree rate rRF i rRF r IP This says that the interest rate earned on a 30day Tbill that is the discount rate equals the REAL riskfree rate plus in ation ii If we rearrange the formula we nd that the real riskfree rate r equals the interest rate earned on a 30day Tbill minus in ation r rm 7 IP iii The in ation premium IP is the expected average annual rate of in ation over the term of the investment 1 In ation is the tendency of prices to rise over time This means that it takes more money to buy things today than it took yesterday In other words in ation decreases your buying power 2 Over the last 29 years that is since the end of 1982 annual in ation has ranged from a low of 0 1 in 2008 to ahigh of 61 in 1990 This had been the most stable period in US history or at least since we ve been keeping track For 2010 in ation was 15 3 Investors would prefer not buy Tbills unless they pay enough to cover the cost of in ation Right now however Tbills are paying less than in ation Currently a 30day Tbill pays approximately 015 If you subtract out the in ation premium of about 15 that means the real rate earned on a 30day Tbill is negative 135 So Tbill investors are actually losing purchasing power c Next we take the nominal riskfree rate rRF and add any other risk premiums to it that we deem appropriate to compensate for the other types of risks that the investment includes This will tell us the market rate r for any particular investment Egt i rrRFDRPMRPLP ii The default risk premium DRP is the amount added to the riskfree rate to compensate the investor for taking on default risk 1 Default risk is the chance that a borrower won t pay back the lender The higher the default risk the higher the DRP 2 To find the default risk premium compare the rates on Tbonds to the rates on corporate bonds with similar terms and features 3 The federal government has never defaulted on its debt so we assume it never will Thus we assume that the DRP on Treasuries equals 0 iii The maturity risk premium MRP is added to the riskfree rate to compensate the investor for investing in longterm instruments and potentially losing the opportunity to invest at higher rates It is also called interest rate risk 1 Imagine that you buy a thirtyyear bond when market rates are at 5 You ve locked yourself into a 5 return Now imagine that market BVchXSHKSGdocx Page 8 FIN 320F Foundations of Finance Section 1 Review rates rise to 10 Since you re lockedin at 5 you ll have to forego the opportunity to earn 10 instead Bummer In general the longer the term to maturity the greater the maturity risk and the higher the MRP 3 Longterm Treasury securities both notes and bonds include an MRP iv The liquidity premium LP is the amount added to the riskfree rate to compensate the investor for assuming some liquidity risk 1 Liquidity risk is the chance that you won t be able to get your invested capital back when you need it The longer it takes to get your money back and the lower the chance of getting ALL your money back the higher the liquidity risk Investments in real estate and small private companies are considered to have higher liquidity risk thus higher LPs than investments in publicly traded stocks and bonds Treasuries are assumed to have no liquidity risk so LP equals 0 2 That s a wonderful theoretical discussion of how to calculate returns but what if I want to calculate my actual returns How do I do that a The amount of dollars that you earn from an investment is the sum of the income from the investment plus the change in the market value of the investment i Dollar return Income Capital gain ii Income is the money that is received from interest payments from bonds dividend payments from stocks or rents from buildings This income is taxable during the year in Which it is earned iii The capital gain or loss equals the ending value of the investment minus the beginning value of the investment 1 A gain or loss is realized when you sell the investment for more or less than you paid for it Realized gains and losses must be reported on your tax return If you haven t sold your investment yet and are just checking its market price in the newspaper then the gain or loss that you calculate is unrealized Unrealized gains and losses are not reported on your tax return b To turn your dollar return into a percentage gure called yield denoted with our friend r simply divide by the beginning value i return Yield r Dollar return Beginning Value ii return Yield Income Capital gain Beginning Value iii return Yield Income End value Beg value Beginning value c After calculating the returns generated by your financial assets compare those returns to an index s returns to make judgments about whether your asset s performance was good or bad An index is an imaginary collection of consumer goods stocks or bonds As the prices of the goods stocks or bonds rise the index rises As the prices fall the index falls An index is used to gauge the performance of assets that are comparable to your own i The Dow Jones Industrial Average aka the Dow the DJ IA is the oldest index It tracks the cost to purchase stocks of the largest 30 US companies The DJIA fell 34 during 2008 rose 24 in 2009 and rose 14 in 2010 N N N BVchXSHKSGdocx Page 9 FIN 320F Foundations of Finance Section 1 Review ii The Standard amp Poor s 500 or SampP 500 is an imaginary collection of stocks from the 500 largest most reputable US rms The rms cover a range of industries and are traded on every major stock exchange The SampP declined 3700 during 2008 and rose 265 during 2009 and another 15 in 2010 iii The Nasdaq Composite index measures the performance of all of the stocks listed on the Nasdaq exchange It fell 41 in 2008 rose 44 in 2009 and rose 18 in 2010 iv The Russell 2000 tracks the performance of 2000 small US public rms It fell 34 in 2008 recovered 27 during 2009 and another 27 in 2010 There are indexes that track bonds international stocks MSCI EAFE DJ World and emerging markets stocks as well Morgan Stanley Select Emerging Markets All can be found in each day s Wall Street Journal or on Y ahoo s or Google s nance pages lt 3 Instead of looking back to see what already happened in the markets you might want to predict what is ahead You can use the collective wisdom of US Treasury investors throughout the world to help you with your forecast A yield curve is a line graph showing the relationship between the interest rates and terms to maturity on Treasury instruments A new yield curve is created each day There are four basic types of results 1 iii Please note Normal curve This is gently upward sloping The spread between a 90day and a 30year Treasury is about 3 percentage points Treasury investors believe the economy is behaving normally and they expect it to continue that way Steep curve This is just a bit steeper than a normal curveithe spread between 90day and 30year Treasuries is greater than 3 percentage points An expansion is expected by Treasury investors Inverted curve An economic death knell Longterm rates are actually lower than shortterm rates We are in or expecting to be in a slowdown in the economy Flat curve Either we are transitioning from normal to inverted or this is just a pause between normal and normal Watch closely The formulas highlighted in red will be recorded on the cover page of your exam BVchXSHKSGdocx Page 10


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