Who issues Bonds?

1. U.S. Government 2. Corporations 3. Local and State Governments 4. Foreign Governments and Corporations

What are the features of a bond?

1. Indentures 2. No Ownership or voting rights 3. Fixed interest payments at set dates, usually twice a year 4. Maturity Date 5. First Claimant

Indenture

Legally binding agreement that defines the bond's terms

First Claimant

In event of bankruptcy, bondholders repaid first

Unique Bond Features

1. Call Feature 2. Put Feature 3. Convertible feature 4. Warrant stock 5. Zero Coupon Feature

Call Feature

Bond issuer redeems prior to maturity

Put Feature

Bondholder can redeem prior to maturity

Convertible Feature

Bondholder can convert into common stock

Warrant Feature

Bondholder can buy common stock

Zero Coupon Feature

Bond sold at discount, doesn't pay interest

What are the two cash flows from bonds?

Interest payments and principal at maturity

How are YTM and a bond's risk related?

The greater the risk, the greater the YYM

Bond Premium

When a bond price > face value

Bond Discount

When bond price < face value

How is the YTM and the price of bonds related?

- As YTM increases, bond price decreases - As YTM decreases, bond price increases

What are the three parts of a bond's risk?

1) Interest Rate Risk 2) Liquidity Risk 3) Default Risk

Interest Rate Risk

• Bondholders are subject to changes in bond prices as interest rates in the economy change • Interest rates (and thus yield to maturity) may vary with economic conditions • As interest rates rise, bond prices fall (and vice versa) • Bond prices are more volatile with respect to interest rate risk • the longer the time to maturity • the lower the coupon payments

Liquidity Risk

• Liquidity refers to how easy it is to trade a security • Bond markets are much less liquid than equity markets • Small firms and less credit worthy firms face significant liquidity risk • Illiquid bonds will trade at a higher YTM (lower price) to compensate investors for liquidity risk

Default Risk

• When bond issuer defaults, bondholder receives no payments • Default risk of a bond is related to the firm’s credit risk • Bond’s trading price will be sensitive to default risk • Required YTM increases (bond price decreases) as default risk increases

Features of Stock

1) Voting Rights and Ownership 2) Dividends 3) Residual Claim 4) Pre-emptive Rights

Dividends

Cash distributed to shareholders

Residual Claim

Shareholders have "residual claim" on assets (in case of distress, only paid after all other claimholders are paid)

Pre-emptive Rights

If new shares are issued, stockholder has right to maintain same percentage ownership by buying proportionate number of new shares

Primary Stock Market

• Market where public companies issue new shares of stock • Companies may list new shares on NYSE, NASDAQ, etc. • Initial Public Offering (IPO) is first time company sells stock to public • Additional stock issues called Secondary/Seasoned Equity Offering (SEO)

Secondary Stock Market

• Where existing shares trade on daily basis • If you buy and sell stock, it occurs here!

Cash Flows from Stocks

Like bonds, two potential cash flows from stocks: 1. Dividends • Unlike interest, company not required to distribute cash to shareholders 2. Capital Gain • Need to sell stock to realize gain since stock doesn't have maturity date

What is the discount rate in stocks?

Required return of stockholders

Market Value of Stock

Average estimate of stock's intrinsic value

Intrinsic Value

Stock's unobservable "true value" - We can only estimate it

If estimate of stock's intrinsic value > market price

Buy!

If estimate of stock's intrinsic value < market price

Sell!

Issues with Finite Models

Predicting future dividends • Future dividends are uncertain • Prior dividends usually good starting point Predicting future selling price • We are trying to estimate stock price today (P0)… • …so how did we estimate future selling price (PN)?

Risk

Refers to uncertainty or chance that a future outcome is different than expected

What are the two types of risk?

1. General Economic Risk 2. Industry and firm-specific risk

General Economic Risk

• Risk factors that affect (almost) all firms (interest rates, inflation, pandemics, wars, etc.) • If economy is in a depression, cash flows of most companies will be low • Sales of cars, other durable goods more likely to be affected by economic downturn • Staples such as food are less likely to be affected

Industry and firm-specific risk

• Risk factors that affect only a particular industry or firm • Technological risk that only affects one industry – can individual firm keep up with industry? • Litigation or disasters may affect a single firm • Changes in product demand (new "green" movement)

Holding Period Return

Refers to the return earned by the investor during entire life of investment

Realized Returns

Actual outcome of investment - Occurred in the past

Expected Returns

Expected outcome of investment - Occurs in the future

Volatility

Measures how individual returns vary from average return

Random Variable

Measurement that can have many possible future outcomes

Probability Distribution

Function that assigns probabilities to the various possible outcomes of a random variable

Discrete Distribution

Probability distribution that can only take a finite number of outcomes

Continuous Distribution

Probability distribution that can take on an infinite number of values

Stand-alone Risk

Risk associated with only holding one asset

What does the Coefficient of Variation measure?

Units if risk for each unit of return

What does a lower coefficient of variation mean?

Less risk given level of return

What does the Sharpe Ratio measure?

Units of excess return for each unit of risk

What does a higher Sharpe ratio mean?

More return for given level of risk

Portfolio

Includes two or more assets

What does the correlation coefficient measure?

How two securities move in relation to each other

What happens to risk when two securities move together?

Less risk is wiped out

What happens to risk when two securities move apart?

More risk is wiped out

What is the typical correlation between stocks?

0.5

What are the three ways to say the same thing about the volatility of an individual security?

1. σ = market risk + firm-specific risk 2. σ = systematic risk + non-systematic risk 3. σ = non-diversifiable risk + diversifiable risk

What are the two sources of volatility?

1. Market-wide events (systematic risk) 2. Firm-specific events (non-systematic risk or diversifiable)

Capital Asset Pricing Model (CAPM)

• Expected returns are a function of relevant risk • Emphasizes difference between systematic and non-systematic risk

Expected/required return comes from two sources:

1. Risk-free component • Can earn with certainty • Dictated by general economic conditions 2. Risk premium • Rm − Rf is referred to as "market risk premium" • Scaling "market risk premium" by Beta i yields asset i's risk-premium

If β = 1.0 and market risk premium is 10%, what kind of risk does the stock have?

Stock has average risk -> Expected risk premium on stock = 10%

If β > 1.0 and market risk premium is 10%, what kind of risk does the stock have?

Stock is riskier than average -> Expected risk premium on stock = 10%

If β < 1.0 and market risk premium is 10%, what kind of risk does the stock have?

Stock is less risky than average -> Expected risk premium on stock = 10%

When does stock market equilibrium occur?

When Expected Return = Required Return (essentially when Market Price = Intrinsic Value)

If expected return > required return, what will investors do?

Investors will buy the security and bid up the price (expected return decreases)

If expected return < required return, what will investors do?

Investors will sell the security and the price will fall (expected return increases)