CH14: YTM is also known as market interest rate - When an investor believes that a bond may temporarily increase

- When an investor believes that a bond may temporarily increase in credit risk, the most liquid method of exploi ng is to purchase a credit default swap
- Accrued interest & quoted bond prices = [(Annual Coupon payment x 2)(Days since last coupon payment/Days separa ng coupon payment)] - The behavior of credit default swaps is that when credit risk increases, swap premiums increases. Credit default swaps do not provide protec on
- Find bond’s current yield: against interest rate risk
o Coupon payment(PMT) = (FV)(Bond’s FV) - ↑ in the firm’s mes interest-earned ra o ↓ default risk of the firm = ↑ the bond’s price = ↓ YTM
o Bond’s current yield(%) = [(Coupon payments/Bond’s selling price)(100%)] - ↑ in the issuing firm’s debt-equity ra o ↑ the default risk of the firm = ↓ bond’s price = ↑ YTM
- Effec ve annual interest (EAR) or at what coupon rate would they pay in order to sell at par? - ↑ in the issuing firm’s quick ra o ↑ short-turn liquidity = ↓ default risk of the firm = ↑ bond’s price = ↓ YTM
o EAR=[(FV/T-Bill selling price)^n]-1, where 12/n or 365/n - Preferred stock commonly pays a fixed dividend
o EAR=[(1+Coupon bond%)^n]-1, where n either annual (1) or semi (2) - Total payment = Coupon payment + Principal repayment
o EAR=[[1+(i/n)]^n]-1, i=coupon rate, n=coupon payment(annual,semi) - The price curve is convex and becomes fla er at higher interest rates
- Given 3 different interest rate, find YTM & Realizable compound yield: - The longer the maturity of the bond, the more sensi ve the bond’s price to changes in market interest rates
o Use calculator for YTM: - Premium bonds: Coupon rate > Current yield > YTM
 PMT=(FV)(Coupon rate) - Discount bonds: Coupon rate < Current yield < YTM
o Realizable compound yield (y realized): YTM HPR
 Future value=[(PMT)(1+r2)(1+r3) + (PMT)(1+r3) + (FV+PMT)] - It is the average return if the bond is held to - It is the rate of return over a par cular investment
 Future value= [(price)(1+y realized)^n] maturity period
- Realized compound YTM if the 1-year interest rate next year turns out to be: - Depends on coupon rate, maturity, and par value - Depends on the bond’s price at the end of the
o Find YTM (FV) holding period, an unknown future value
o Future CF=[(1st year PMT)(1+r) + (1st year PMT + FV)], where r=interest rate - All of these are readily observable - Can only be forecasted
o Realized compound yield to maturity (%)=[(Future CF/Price)^(1/2)]-1 - Investment grade bonds are rated BBB/Baa or above
- Price=FV/[(1+YTM)^n], FV is price that pays at maturity for 0-coupon bond - Specula ve-grade/junk bonds are rated below BBB/Baa
- Find rate of return (before tax holding period return on each bond) (%): - Determinants of bond safety: coverage ra os, leverage ra o, debt to equity ra o, liquidity ra o, profitability ra o, cash flow to debt ra o
o For 0-coupon bond=[(price 1 year from today – current price)/(current price] x 100% - Bankruptcy is predict using the discriminant analysis
o For the one with coupon rate=[(price 1 year from now – current price + PMT)/(current price)] - Promised YTM will be realized only if the firm meets the obliga ons of the bond issue
o Normal=[(PMT + Price n me from today – Price Today)/(price today)] - Expected YTM must consider the possibility of a default
- Bond equivalent yield(%)=[(YTM)(Original PMT)], where YTM is calculated from calculator by n=(n)(semi-annual) and PMT=(PMT)(original n) - Structure of interest rate is the rela onship between the interest rate on a security and its me to maturity
o For 0-coupon bond=[(FV/PV)^(1/n)]-1 - Bond stripping and bond recons tu on offer opportuni es for arbitrage, which can occur if the law of one price is violated
- Effec ve annual yield to maturity(EAR)=[(1+YTM)^(original PMT)]-1, where YTM is calculated from calculator by n=(n)(semi-annual or annual) and - The yield curve shows at any point in me, the rela onship between yield on a bond and the me to maturity on the bond
PMT=(PMT)(original n) - The yield to maturity on a bond is the discount rate that will set the present value of the payments equal to the bond price
- Coupon rate must divide by 2 is paid semi-annually - Intrinsic value of the bond today (Vo or Po) = compute PV
- Invoice price on the bond: - A bond with the highest maturity period, and the lowest coupon rate would be the bond with the longest dura on
o Quoted price or flat price=(Ask price or Selling price)(10) - (1+coupon rate)^n = (1+f1)(1+f2)(1+f3), where coupon rate is the YTM on a n year zero-coupon bond
o Interest accrued=[(Semi-annual coupon or annual)(Interest on n days/Coupon period)] - Purchase price of a n year zero-coupon bond:
 Ex. Coupon payments on Jan.15-July 15. Report ask price on Jan.30. Then interest on n days(Jan.15-Jan.30) = 15 Year 1-year forward rate (r) (1+r)
days 1 %, given (f1) (1+r)
 Coupon period, if not given then must divide by 12 months or 365 days, depends on numerator of days or months. 2 %, given (f2) (1+r)
 If semi-annual, must divide PMT by 2 N=given
o Invoice price=Quoted price + Accrued interest Par value (FV)= 1,000 or given
 Invoice price includes accrued interest while quoted price is clean price which does NOT include accrued interest Purchase price = [(FV)/(1+f2)(1+f3)]
- Real and Nominal rate of return on the RRB bond: - An investment in a coupon bond will provide the investor with a return equal to the bond’s YTM at the me of purchase if the reinvestment rate is the
o 2nd year Nominal=[(Interest + Capital gain)/(beg. price)] = [(PMT) + (2nd year par - 1st year par)/(1st year par)] x100 same as the bond’s yield to maturity and the bond is held un l maturity
o Real=[(1+Nominal)/(1+Infla on)]x100% - A bond with a call feature is more apt to be called when interest rates are high b/c the interest saving will be greater
- Imputed interest income: CH.15
- The YTM of each bond, the implied sequence of forward rate, expected price, expected rate of return:
Year Remaining maturity (T) Constant Yield Value Imputed Interest (increase in Maturiy Price of bond
[(FV)/(1+YTM)]^T constant yield value) o YTM:
0 20 years (now). This is given in the Blank (for this one only)  Maturity 1 (n=1): compute I/Y or =[(FV, 1000 / 1st price)^(1/# of years to maturity)]-1
ques on o Implied sequence of forward rate:
1 0 Last year  1st year forward rate(%) = [(FV/1st year price)-1]x100%
- Total taxable income=[(PMT)+(Price in 1 year – Original price)]  2nd year forward rate(%) = [(1st year price of bond/2nd year price of bond)-1]x100%
- Yield to call: o Expected price:
o Find price (PV), use calculator (normal n, not n callable)  1st year= [(FV)] / [(1+1st year forward rate)(1+2nd year forward rate)(1+3rd year forward rate)(1+4th year forward
o Find I/Y from the PV calculated above (yield to call), where n is callable and mes by semi-annual if needed rate)]
 If given FV(Call price), then compute I/Y using FV given and PV calculated above  2nd year=[(FV) / (1+2nd year forward rate)(1+3rd year forward rate)(1+4th year forward rate)]
o Low interest rate: the price of the callable bond is flat since the risk of repurchase or call is high o Expected rate of return:
o High interest rate: the price of the callable bond converges to that of a normal bond since the risk of call is negligible  1st year=[(2nd year expected price)/(1st year expected price)]-1
- Stated & Expected YTM (compute I/Y):  Last year=[(FV)/(last year expected price)]-1
o Stated: use original PMT - Expected 1-year interest rate 3 years from now:
o Expected: use new PMT=(Original PMT/2), if said to reduce coupon payment to one half the original contracted amount
- HPR for 1 year investment period, if its bond is selling at a YTM=%: Bond Years to maturity YTM (%)
o Ini al price (Po) = compute PV A 3 6.5
 Ex. Maturity is 20 years (n=20) B 4 7
o Next year’s price (P1)= compute PV Expected 1-year interest rate 3 years from now =[[(1+4th year YTM)^4 / (1+3rd year YTM)^3] -1] x 100%
 Maturity here is 1 year less than the one above (Ex. N=19)
o HPR(%)=[[(Coupon Payment,PMT) + (P1-Po)]/(Po)]x100% - Expected the rate of return to be over the coming year on a 3-year zero-coupon bond and Forward rate:
 A er tax HPR=[[(Coupon Payment,PMT) + (P1-Po) – (Total taxes)]/(Po)] x 100% Maturity (years) YTM (%)
- Find current yield: 1 4%
o Current yield=[(Original PMT, annually)/(price)]x100% 2 5%
o YTM: use semi-annual PMT 3 6%
- Find conversion premium: o Current price of a 3-year bond with a FV $#= [(FV)/(1+YTM)^n], 3-year bond (n=3, YTM=6%)
o Market conversion value (or value if converted into stock) = [(Conversion ra o)(Market price of underlying common stock)] o Price of a 3-year bond next year(n=2) = [(FV)/(1+YTM)^n]
o Conversion premium = Bond price – Market conversion value o Total return over the coming year = (Price of 3-year bond next year) – (Current price of 3-year bond)
- The bond with the same maturity & coupon rate but different callable: the one with lower callable will have higher YTM. So the higher bond callable o Expected rate of return over coming years = [(Total return over the coming years)/(Current price of 3-year bond)]x100%
should sell at a higher price o Forward rate:
- Stated YTM and Realizable compound YTM of a default-free (0-coupon bond) will always equal  2nd year=[(1+2nd year forward rate)^2] / [(1+1st year forward rate)^1]
- Bond prices go down when interest rates go up. o Calculate the forward 1-year rate of interest for year 3 (year 3 forward rate = year 4):
- If the bond’s YTM remains constant, then in 1 year, the bond price will be lower. As me passes, the bond price (which is now above par value) will  4th year forward rate=[(1+4th year YTM)/(1+3rd year YTM)]-1
approach par - What price will bond sell [given 2 different YTM (1st YTM, 2nd YTM) and 2 mes to maturity (1st n, 2nd n)]:
- Bond with annual payments are less a rac ve to investors b/c more me elapses before payments are received o New P=[(PMT)/(1+1st YTM)^n] + [(FV+PMT)/(1+2nd YTM)^n], n=1 for 1st YTM, n=2 for 2nd YTM
- YTM > Current Yield = bond selling below par value o YTM=compute I/Y from P calculated above and use the higher n
- YTM < Current yield = bond selling above par value o Arbitrage profit from this strategy = (Original price – New price)
- All else equal, if a bond’s YTM increases, its price will fall  Original P: Compute PV
 - Market expecta on of the price that the bond will sell for next year (with 2 YTMs, and 2 n): 1 = PMT = [(CF)/(1+YTM)]^n = [(PV of CF =(n)(Weight)
o F2 (forward rate next year)=[(1+2nd YTM)^n] / [(1+1st YTM)^n] value)/(Column sum of
o Market expecta on of the price that bond will sell next year or Expected price (P) = [(FV + PMT) / (1+F2)] PV of CF)]
o Expected rate of return over the 1st year(HPR) = [(PMT + Expected price – Coupon price) / (Coupon price)] 3 (last one) = (FV + PMT) = [(CF)/(1+YTM)]^n = [(PV of CF
o Forecast interest rate[E(r2)]=[f2-liquidity premium]x100%, given liquidity premium value)/(Column sum of
 Forecast of the bond price=[(FV+PMT)/(1+E(r2))], E(r2) or f2 PV of CF)]
Column sum PV of CF column sum Weight column must This value is the sum of
always = 1 this column (DURATION)
-Zero-coupon bonds of various maturi es:
o If the above is semi-annual, then must divide coupon rate by 2, mul ply n by 2, divide YTM by 2
o Dura on (in years) = [(n)x[[CF/(1+YTM)^n]/Price]], price is the sum of PV of CF. Part highlighted in grey can be use to find weight(W)
Maturity (years) Zero-Coupon price o Market value of that 0-coupon bond (o PV of the obliga on)= (Sum of PV of CF)
o YTM of a bond that matures in 3 years: o Face value of that 0-coupon bond (or the future redemp on value)= [(Sum of PV of CF)(1+YTM)^(dura on)]
 Current bond price=[(PMT)+(1 year price/FV)] + [(PMT) + (2nd year price/FV)] + [(PMT) + FV + (3rd year price)], last
st
o Interest rate (YTM) ↑ to % , value of zero-coupon bond will be:
price must ad an extra FV  PV = [(FV)/(1+YTM)^(dura on)]
 Use this price to calculate the I/Y (use calculator) - Which bond should you buy? (given 3 different year, 3 different bond yield, coupon rate, and longer-maturity bond yield):
o 1-year HPR on the coupon bond: 1-year 2-year 3-year
 n=2 (subtract 1 year from the given year), YTM (the yield curve fla ens out at %), compute PV 1. YTM at the Bond yield given (YTM) Bond yield given (YTM) Bond yield given (YTM)
o HPR =[[(PMT)+(Bond price one year from now – Current bond price)] / (Current bond price)]x100% beg. of the
- Prices of zero-coupon bonds reveal the following: year
Year Forward Rate 2. Beg. of the Compute PV Compute PV Compute PV
o Price of coupon bond=[(PMT/(1+1st year forward rate)] + [(PMT)/(1+1st year forward rate)(1+2nd year forward rate)] + [(FV+PMT)/(1+1st year price n=1 n=2 n=3
nd rd
year forward rate)(1+2 year forward rate)(1+3 year forward rate)] 3. Prices at year PV = 1,000 n=1 n=2
 Price of 3-year zero coupon = purchase price = [(FV) / (1+fo)(1+f2)(1+f3)] end (at longer
o Expected realized compound yield of the coupon bond: maturity bond Compute PV Compute PV Compute PV
 Future value of bond (FV) = [(PMT)(1+2nd year forward rate)(1+3rd year forward rate)] + [(PMT) + (1+3rd year forward yield)
rate)] + [(PMT+FV)] 4. Capital ③-② ③-② ③-②
 Expected realized compound yield (y realized): (PV)(1+y realized)^n = FV gain/losses
o HPR = [(PMT) + (Bond price one year from now – Current bond price)] / (Current bond price) 5. Coupon (PMT) =(FV)(Coupon rate) =(FV)(Coupon rate) =(FV)(Coupon rate)
Same for all 3 years
- Prices of zero-coupon bonds with various maturi es:
6. 1-year total =[(③+⑤-②)/(②)] x 100% =[(③+⑤-②)/(②)] x 100% =[(③+⑤-②)/(②)] x 100%
rate of return
Maturity Price - How much of each of these coupon bonds (in market value) will you want to hold to both fully fund and immunize your obliga on:
o Forward rate (F1) = [(FV)/(1st year price)] -1 o PV of obliga on = [(Perpetual payments)/(YTM)]
o Forward rate (F2) = [(1st year price)/(2nd year price)] -1 o Dura on of perpetual obliga on = [(1+YTM)/(YTM)]
o 1-year forward loan beg. in year 3 (which is year 4): o Given 2n, 2 dura on, 2 coupon rate:
 Price of 4-year zeros=(3rd year price/4th year price)  Dura on of perpetual obliga on (weight,w) = [(w)(shorter dura on)]+[(1+w)(longer dura on)], find w
o Rate on synthe c loan=(1)-(Price of 4-year zero)  $ want to hold (holding), for shorter n= [(w)(PV of obliga on)]
- Forward rate = Market’s expecta on of the future short rate + Poten al risk (or liquidity) premium  $ want to hold (holding), for longer n= [(1-w)(PV of obliga on)]
- Expecta ons hypothesis: o At what par value of your holdings in n-year coupon bond:
o If the yield curve is upward sloping, the market must expect an increase in short-term interest rates  Coupon rate = short coupon rate (given)
o There are no risk premia built into bond prices  Compute PV
o States forward rate = market consensus expecta on of future short interest rate  Bond sells for = (PV/FV), FV=1,000
o F2=E(r2) and liquidity premium are zero  Market value = (Par)(Bond sells for), find Par value
o A normal yield curve implies that interest rates are expected to increase in the future - Given target dura on, find how much of each bond will you hold in your por olio:
- Liquidity preference theory: o Dura on of perpetual = (1+YTM)/(YTM)
o According to the “liquidity preference” theory of the term structure of interest rates, the yield curve should be normal and upward o Target dura on=[(w)(maturity)] + [(1-w)(dura on of perpetual obliga ons)], find w. Use this when only given 1 maturity
sloping  Weight for 0-coupon bond with maturity of n years = target dura on
o It is uncertain that if infla on is expected to be falling over the next few years, long-term interest rates will be higher than short-term  Weight for perpetuity, each currently yielding % = 1-w
rates  Target dura on (in years) = (w)(dura on) + [(1-w)(perpetuity dura on)]
o Expecta on of lower infla on will usually lead to lower nominal interest rates - Short-term rates are more vola le than long-term rates, the longer dura on of the long-term bonds makes their prices and their rates of return more
o If this is true, the shape of the term structure should be upward sloping in a period where interest rates are expected to be constant vola le. The higher dura on magnifies the sensi vity to interest rate changes
o The liquidity premium is (+) so that the forward rate > the market’s expecta on of the future short rate - Intermarket spread swap:
o Assumes that the financial markets are dominated by short-term investors who demand a premium in order to be induced to invest in o If current yield spread btw AAA bonds and Treasury bonds is too wide compared to historical yield spreads and is expected to narrow,
long maturity securi es you should shi from Treasury bonds into AAA bonds. As the spread narrows, the AAA bonds will outperform the Treasury bonds
o Long term bonds are more risky [f2>E(r2)] - If interest rates are about to ↓, the zero coupon, long maturity bond will give you the highest capital gain
o The excess of f2 over E(r2) is the liquidity premium (predicted to be +) o Investors tend to purchase longer term bonds when they expect yields to fall so they can capture significant capital gains, and the lack
- Pure expecta on theory (unbiased theory): of a coupon payment ensures the capital gain will be even greater
o A yield curve that is upward (downward) sloping, means that short-term rates are expected to rise (fall) - Interest rate sensi vity:
o A flat yield curve implies that the market expects short-term rates to remain constant o Bond prices & yield are inversely related
o If this is true, upward-sloping yield curve = interest rate are expected to ↑ in the future o ↑ in a bond’s YTM = smaller price change than a ↓ of equal magnitude
o Forward rates is exclusively represent expected future spot rates o Long-term bonds tend to be more price sensi ve than short-term bonds
- Term structure of interest rate: o Maturity ↑, price sensi vity ↑ at a ↓ rate
o The liquidity preference theory contends that lenders prefer to buy securi es at the short end of the yield curve o Interest rate risk is inversely related to the bond’s coupon rate
o Yield curve is a good predictor of the business cycle (long term rates tend to ↑ in an cipa on of economic expansion, inverted yield o Price sensi vity is inversely related to the YTM at which bond is selling
curve may indicate that interest rate are expected to ↓ and signal a recession) - Dura on = maturity for zero-coupon bonds
o An upward sloping curve could indicate that the rates are expected to ↑ and/or investors require large liquidity premiums to hold long - Dura on < Maturity or coupon bonds
term bonds - Dura on rules:
Pure Yield Curve On-the-Run Yield Curve o Rule 1: the dura on of a zero-coupon bond = its me to maturity
- Uses stripped or 0-coupon Treasuries - Refers to the plot of yield as a func on of maturity o Rule 2: Holding maturity constant, a bond’s dura on is lower when the coupon rate is higher
- May differ significantly from the on-the-run yield for recently issued coupon bonds selling at or near o Rule 3: holding the coupon rate constant, a bond’s dura on generally increase with its me to maturity
curve per value o Rule 4: Holding other factor constant, the dura on of a coupon bond is higher when the bond’s yield to maturity is lower
- The one typically published by the financial press o Rule 5: the dura on of a level perpetuity is = [(1+y)/(y)]
- Spot rates: the rate that prevails today for a me period corresponding to the 0’s maturity - Convexity (∆P/P):
- Short rate: applies for a given me interval (e.g., 1 year). Refers to the interest rate for that interval available at different points in me o Rela onship btw bond prices and yields is not linear
CH.16: o Bonds with higher convexity exhibit higher curvature in the price-yield rela onship
- Highest n, lowest coupon bond will give the longest dura on o ∆P/P = (-D)(∆y) + (1/2)[(Convexity)(∆y)^n]
- An analysis who selects a par cular holding period and predicts the yield curve at the end of that holding period is engaging in horizon analysis o Investors must pay higher prices and accept lower YTM on bonds with greater convexity
- Bond price = (-D, dura on)(∆yield m, change in market yield)(Par) o As rate ↓, there is a ceiling on the bond’s market price, which cannot rise above the call price
- % change in the bond’s price=[[(-dura on,d)/(1+yield,y)](Change in market yield, ∆y)]x100% o As rate ↓, the bond is subject to price compression
- Find dura on (or what maturity bond must it purchase, what maturity would immunize your obliga on)?  Effec ve dura on = -[(∆P/P)/(∆r)]
Time to payment (n, in Cash flow (CF), this is PV of CF (discount rate = Weight (Time to - 2 classes of passive management: Indexing strategy, and immuniza on techniques
years) the PMT coupon rate), if not maturity)(Weight) CH.18:
given, then use YTM
o g(%) = growth rate, expected growth rate (expected to grow), market’s expecta on of dividend growth rate, dividend growth forecast, dividend growth o As ROE ↑
rate o As plowback (b) ↑, if ROE > k
o Do = current dividend, currently pay a dividend o As plowback (b) ↓, if ROE < k
o D1 = year-end dividend for the 1st year o As k ↓
o Po = current shares value, current market value, current selling price, intrinsic value of the stock (its true value), current stock price, market price of a - Po/E1 = [(1-b) / (k-(ROE)(b))]
share - P/E = (1-b) / (k-g)
o P2 = value of stock at the end of 2nd year o Riskier firms will have higher required rate of return (k), which means the P/E mul ple will be lower
o Vo = value of stock today, current stock price CH.19:
o K = required return, expected return, rate of return, market capitaliza on rate - Inventory turnover ra o = (COGS / Average Inventory)
o E = earnings - Debt/Equity ra o = (Debt/Equity) = (Total liability / Total equity)
o PVGO = present value of growth opportunity - Average collec on period (days) = [(Average receivable) / (Sales/365)]
o b= plowback ra o Net income (or earnings)
o B = Beta Adjustments for:
o E(rm) = market return, expected rate of return on market Deprecia on
o Rf = risk-free rate (T-bill return) +/- in A/R
o EPS = expected earnings per share, expected earnings +/- in Inventories
o FCFF = free CF to the firm +/- in A/P
o t = tax rate, corporate tax rate ______________________________
CF from opera ng ac vi es
o Ke= cost of equity
o V = market value of equity - Asset turnover ra o = (Sales / Average Asset)
o ROE = return on equity, return on invested project - Interest coverage ra o = (EBIT / Interest Expense)
o E(r) = Expected 1-year holding period return - Opera ng profit margin (or return on sales) = (EBIT / Sales)
o IV = intrinsic value (true value) - Return on equity (ROE, %) = (NI / Average Shareholder’s equity)
o MV = market value (consensus value) - P/E ra o = (Price share / Earnings share)
- Do = (EPS)(Paying out to its dividend) - Compound leverage ra o (CLR) = [(EBIT – Interest expense)/ EBIT] x [(Average Assets / Average Equity)]
- D1: - Net cash provided by opera ng ac vi es = Cash Flow from opera ng ac vi es
o = (Do)(1+g) - ROA (return on asset) = ROS (Return on sales) x ATO
o = (Next year’s earnings)(1-b) - ROE = (1-Tax rate)[(ROA) + (ROA – Interest rate)(Debt/Equity)]
o = (Eo)(1+g)(1-b) o Firm A and B have the same ROA. Assuming the same tax rate and assuming that ROA > interest rate then Firm A must have either a
o = (EPS)(1-b) lower interest rate or a higher debt ra o
o = (Paying out)(EPS) - ROE = (Opera ng margin)(Interest burden)(Asset turnover)(Leverage)(Tax burden)
- D2 = (D1)(1+g) - Profit margin = (EBIT/Sales)
- D4 = (D3)(1+g) - Interest burden = (Pretax profits / EBIT)
- P2= [(D3)/(k-g)] - Asset turnover = (Sales / Total assets)
- Vo = [(D1)/(1+k)^1] + [(D2 + P2)/(1+k)^2] - Leverage = (Assets / Equity)
- 2-stage dividend discount model: - Tax burden = (Net profit / Pretax profit)
o Vo=[(D1)/(1+k)^1] + [(D2 + P2)/(1+k)^2] + [[(D3)/(k-g)]/(1+k)^2]
- K(%): = (Income taxes / Pretax income) x 100%
o = [(D1/Po) + g] = [(Paying out)(EPS) / (Po)]
o = rf + [Beta[E(rm) – rf]]
- Opera ng margin = [(Opera ng income – Deprecia on)/(Sales)]
 If stock is priced correctly, k=expected return
- Asset turnover = Sales / Total assets
- DDM method:
- Interest burden = [(Opera ng Income – Deprecia on)-(Interest expense)] / (Opera ng income – Deprecia on)
o Current share value (Po) = [(1+g) / (k-g)]
- Financial leverage = (total assets / shareholder’s equity)
o Current stock price (Po or Vo) = [(Do)(1+g) / (k-g)], where (Do)(1+g) = D1
- Income tax rate = (Income taxes / Pretax income)
o Vo = [(D1)/(1+k)] + [(D2)/(1+k)^2] + [(D3)/(1+k)^3]
- DuPont system:
- Constant growth DDM:
o ROE = (NI / Equity) = (NI/Sales)(Sales/Assets)(Assets/Equity) = (Net profit margin)(Asset turnover)(Leverage ra o)
o Vo = [(Do)(1+g) / (k-g)] = (D1)/(k-g)
o ROE = (NI / Equity) = (NI / Taxable income)(Taxable income/EBIT)(EBIT/Sales)(Sales/Assets)(Assets/Equity) = (Tax burden ra o)(Interest
- Po:
burden)(Return on sales)(Sales firm generated)(Leverage ra o)
o = [(E1/k) + PVGO]
o Net profit margin = (NI,Net profit)/(Sales)
o = (D1)/(k-g), intrinsic value of a share
o Total asset turnover = (Sales / Assets)
o = (E1)/(k), assuming ROE = k
o Leverage ra o = (Assets / Equity)
- g = (ROE)(b)
o G(growth rate) = (ROE)(Plowback), where plowback = (1-Dividend payout ra o)
- P3:
o ROE = (NI/Equity)= (Net profit / Pretax profits)(Pretax profits / EBIT)(EBIT/Sales)(Sales/Assets)(Assets/Equity) = (Tax-burden
o = (Po)(1+g)^3
ra o)(Interest burden ra o)(Profit margin / return on sales)(total asset turnover, ATO)(Leverage ra o)
o = (D4)(k-g)
- ↓ Bad debt expense = ↑ opera ng income
- P/E ra o = P/E
o ↓ bad debt will have no effect on opera ng CF
o Leading P/E ra o = (Po)/(E1)
Sale of old equipment (Repurchase of stock) Cash collec ons from customers
o Trailing P/E ra o = (Po)/(Eo)
(Purchase of bus) (Cash dividend) (Cash payments to suppliers)
- E1 = (Eo)(1+rf)
Net cash provided by/used inves ng Net cash provided by/used in financing (Cash payments for interest)
- PVGO:
o = [(Po) – [(E1) / (k)]] ac vi es ac vi es Net cash provided by opera ng ac vi es
o = [(Po) – (EPS/k)]
(make sure to nega ve this value at the end)
- FCFF = (EBIT – Deprecia on)(1-Tax rate) + Deprecia on – Capital Expenditure - ∆NWC
Net increase/decrease in cash for the year = Inves ng + (- Financing) + Opera ng
- FCFE = (FCFF) – (Interest expense)(1-t) + (↑↓ in net debt)
- Economic value:
- V = [(FCFE1)/(Ke – g)], where FCFE1= (FCFE)(1+g)
o Total capital of the firm = (Debt + Equity)
- Dividend payout ra o = (D1)/(EPS)
o Economic value = (ROC – Cost of Capital)(Total capital of the firm)
- Plowback ra o (b) = (1 – Dividend payout ra o)
 Spread (ROC) is smaller meaning that their larger capacity stock allows them more economic value added
- ROE (%) = (g/b)
o Economic value added per dollar = [(Economic value) / (Total capital of the firm)]
- Paying out= 100% - Payout to its dividend
Cash collec on from customers (Re rement of common stock) (Purchase of land)
- E(r) = [(D1 + P1 – Po) / (Po)]
(Cash payments to merchandise suppliers) (Payments of dividends) Sale of equipment
- P1 = V1 = Vo (1+g)
(Cash payments for interest) CF from financing ac vi es (Purchase of equipment)
- PV of expected price = [(Expected price) / (1+k)^years] (Cash payment for salaries) CF from inves ng ac vi es
- Expected dividend yield = D1/Po
CF from opera ng ac vi es Make sure to nega ve this value at the end
- Implied capital gain = (P1 – Po)/(Po)
- 2 responsibili es of a firm’s financial managers:
- The lower P/E ra o is evidence of the diminished op mism concerning the firm’s growth prospects. Low P/E ra os & -PVGO are due to a poor ROE
o Investment decisions
(that is less than the market capitaliza on rate
 Pertain to the firm’s use of capital: the business ac vi es in which it is engaged
- Vo ↑ b/c the firm pays out more earnings instead of reinves ng a poor ROE
o Financing decisions
- Trading signal:
 Pertain to the firm’s sources of capital
o IV > MV ; buy
- ROA (return on asset) = (EBIT / Total assets)
o IV < MV ; sell
- ROC ((return on capital) = (EBIT) / (Long term capital)
o IV = MV ; hold
- ROE (return on equity) = (NI / Shareholder’s equity)
- P/E ↑:
 - No debt or ROA = r → ROE = (ROA)(1-t) - APT replies on there key proposi ons:
o If ROA > r, the firm earns more than it pays out to creditors and ROE increases o Security returns can be described by a factor model, there are sufficient securi es to diversify away idiosyncra c risk, well-func oning
o If ROA < r, ROE will decline as a func on of the debt-to-equity ra o security markets do not allow for persistence of arbitrage opportuni es
- Current ra o = Current asset / Current liabili es - Law of one price:
- Quick ra o = (Cash + Marketable securi es + Receivables) / (Current liabili es) o Enforced by arbitrageurs; if they observe a viola on they will engage in arbitrage ac vity
- Cash ra o = (Cash + Marketable securi es) / (Current liabili es) o This bids up (down) the price where it is low (high) un l the arbitrage opportunity is eliminated
- Market-book-value (P/B ra o) = market price of a share of the firm’s common stock / its book value - All well-diversified por olio with the same beta must have the same expected return. For any well-diversified P, the expected excess return must be:
- Price-earnings (P/E) ra o = stock’s price / its earnings per share o E(Rp) = BetapE(RM)
CH.20: APT CAPM
- Put call parity theorem: - Built on the founda on of well-diversified - Model is based on an inherently unobservable
o C + [X/(1+rf)^T] = So + P , where [X/(1+rf)^T] = PV(x) por olios “market” por olio
 C = call premium, price of call op on - Does not assume investors are mean-variance - Provides unequivocal statement on the expected
 X = strike price, exercise price op mizers return-beta rela onship for all securi es
 Rf = risk-free - Uses an observable market index
 T = me in years (#/12 months, #/365 days) - Does not require the restric ve assump ons of
 So = ini al price of underlying the CAPM and its market por olio
 P = put premium, price of put op on - What is a good market: providing informa on, consump on ming, risk alloca on
o Total cost = (Price of call op on + Price of put op on) - Systema c risk: a loss of ability to move and store money
- Stock price would have to move in either direc on by: Primary market Secondary market
- New issues of securi es are offered to the public - Trades in exis ng securi es take place here,
here, issuer receives the proceeds from the sale investors trade previously issued securi es among
= (Total cost)(1+rf)^T, this # is before the profit become nega ve themselves, issuing firm doesn’t receive proceeds
- Rf = (X/Net outlay) -1 and is not directly involved
- Breakeven stock price = strike price – total cost - Cer ficates of Deposit (CD):
- Conversion value = (Market price of the common stock)(Conversion ra o) = (Current market price)(Conversion ra o) o Short-term, more liquid, low risk, o en have large denomina ons
- Market conversion price = (Market price of the conver ble bond / Conversion ra o) = [(Market price)(Par value) / (Conversion ra o)] o The risk premium on CD over T-bills have o en become greater during periods of financial crisis
- Profit = (Higher exercise price) – (Lower exercise price) + (Call op on with higher exercise price) – (Call op on with lower exercise price) Ask price Bid price
- Maximum profit that you could gain (Profit/Loss on put) = [(-put premium)(Amount of put contract)] + [(Amount of put contract)(Units per contract)] - Is the price you would have to pay to buy a T-bill - Is slightly lower price you would receive if you
- In the money: occurs when exercise would product +CF from a securi es dealer wanted to sell a bill to a dealer
o Call op on = asset price > exercise price - This is the price you receive (from dealer - Are offers to buy
o Put op on = asset price < exercise price perspec ve) - In dealer markets, the bid price is the price at which
- Out of the money: exercise would result in a -CF - The cost you have to accept if you want the goods the dealer is willing to buy
- At the money: exercise = asset prices - Is usually higher than the bid price in the market
American op on European op ons - Ask price are sell offers
- Allows its holder to exercise the right to purchase (if - Allow for exercise of the op on only on the - IN dealer markets, the ask price is the price at which
a call) or sell (if a put) the underlying asset on or expira on date the dealer is willing to sell
before the expira on date - Wait un l maturity to buy the underrealized assets - Investors must pay the ask price to buy the security
- Buy the underlying assets (on or before maturity), - Can sell op ons whenever
can only buy the underlying asset
- Sell op on before expira on date Money market Capital market
- You purchased one BCE March 50 call and sold one BCE March 55 call. Your strategy is known as a ver cal spread - Are made up of short-term, marketable, liquid, low- - Include longer term and risker securi es
- Some more “tradi onal” assets have op on-like features; some of these instruments include callable bonds, conver ble bonds, and warrants risk debt securi es - Maturity longer than 3 years
- Proponents of the EMH think technical analysts are was ng their me - Is part of fixed income - More risk
- Market por olio has a beta of 1 - Less risk
- In a well-diversified por olio, unsystema c risk is negligible - Types of orders:
- The APT differs from the CAPM b/c the APT recognizes mul ple systema c risk factors o Market orders: are buy or sell orders that are to be executed immediately at current market prices
Weak-form of EMH Semi-strong form of EMH Strong-form of EMH o Price-con ngent order:
- Asserts that stock prices - Asserts that stock prices - Asserts that stock prices Price below the limit Price above the limit
already reflect all already reflect all publicly reflects all relevant -Limit-buy order Stop buy order
informa on contained in available informa on, but informa on, including > may instruct the broker to buy some  Specify that a stock should be
the history of past prices not informa on that is insider informa on number of shares if and when Enbridge bought when its price rises above a
- All version assert that available only to insider - All version assert that can be obtained at or below a s pulated limit
prices should reflect - All version assert that price prices should reflect price  These trades o en accompany
available informa on should available available informa on short sales, and are used to limit
informa on poten al losses from the short
- Covariance between the returns on 2 stocks = [(Beta 1)(Beta 2)(standard devia on m)^2] posi on
- To maximize expected u lity, must choose the highest expected rate of return, and the lowest standard devia on -Stop-loss order -Limit-sell order
- According to the mean-variance criterion, the investment that dominates all other investments is the one with the highest E(r), and the lowest variance > similar to limit orders
- Role of financial market: > trade is not to be executed unless the  Instructs the broker to sell if an
o Consump on ming, Informa on, Separa on of ownership, risk alloca on stock hits a price limit when the stock price rises above a
- Financial assets permit: > the stock is to be sold if its price falls specified limit
o Consuming ming, alloca on of risk, separa on of ownership below a s pulated level
- Mechanisms that have evolved to mi gate poten al agency problems: > the order lets the stock to be sold to
stop further losses from accumula ng
o Using the firm’s stock op ons for compensa on, Boards of directors forcing out underperforming management, Security analysts
- Limit order book:
monitoring the firm closely, take over threats
o A collec on of limit orders wai ng to be executed. The limit orders are listed with the best orders first – the orders to buy at he highest
- Asset alloca on: the alloca on of assets into broad asset classes
price and sell at the lowest price
Bo om-up Top-down
 Selling side: high price first
- Using security analysis to find securi es that are - Refers to using asset alloca on as a star ng point
 Buying side: low price first
a rac vely priced (starts with security analysis)
- Effec ve spread = (transac on price – midprice)(2)
- New issuers of securi es are sold in the primary market(s)
- Everyone invests in P, regardless of their degree of risk aversion:
- Put op on: allows holder to sell the underlying asset at the strike price on or before the expira on date
o More risk averse investors put less in P
- The cost of buying and selling a stock consists of: broker’s commissions, dealer’s bid-asked spread, and a price concession an investor may be forced to
o Less risk averse investors put more in P
make
- Stock prices should follow a random walk:
- Rela ve strength = (Security Price / Industry Price Index)
o Stock price changes are random and unpredictable. Necessary consequence of intelligent investors compe ng to discover relevant
- EMH:
informa on on which to buy or sell stocks before the rest of the market becomes aware of that informa on
o Prices of securi es fully reflect available informa on
o Investors buying securi es in an efficient market should expect to obtain an equilibrium rate of return

Ac ve Management Passive Management

- An expensive strategy - No a empt to outsmart the market
- Suitable only for very large por olios - Accept EMH
- Index Funds and ETFs
- Low-cost strategy