1. Exam 2 Review

2. Basic Concepts  Fisher Effect -- (1 + k rf ) = (1 + k*) (1 + IRP) -- (1 + k rf ) = (1 + k*) (1 + IRP)  Expected rate of return -- k = P(k 1 )*k 1 + P(k 2 )*k 2 +...+ P(kn)*kn -- k = P(k 1 )*k 1 + P(k 2 )*k 2 +...+ P(kn)*kn

3. What is Risk?  Uncertainty in the distribution of possible outcomes.  How can we measure it? -- Standard Deviation -- Standard Deviation

4. Standard Deviation = (k i - k) 2 P(k i )  n i=1 

5. It depends on your tolerance for risk! Remember, there’s a tradeoff between risk and return. Return Risk

6.  Combining several securities in a portfolio can actually reduce overall risk (diversification) How can we reduce risk?

7. Some risk can be diversified away and some cannot.  Market risk (systematic risk) is nondiversifiable. This type of risk cannot be diversified away.  Company-unique risk (unsystematic risk) is diversifiable. This type of risk can be reduced through diversification.

8. This is why we have Beta. Beta: a measure of market risk.  Specifically, beta is a measure of how an individual stock’s returns vary with market returns.  It’s a measure of the “sensitivity” of an individual stock’s returns to changes in the market.

9.  A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.  A firm with a beta > 1 is more volatile than the market.  (ex: technology firms)  A firm with a beta < 1 is less volatile than the market.  (ex: utilities) The market’s beta is 1

10. Portfolio Beta  Beta of Portfolio = Σ (percent invested in stock j) * Σ (percent invested in stock j) * (Bate of stock j) (Bate of stock j)

11. k j = k rf + j (k m - k rf ) where: where: k j = the required return on security j, k rf = the risk-free rate of interest, j = the beta of security j, and j = the beta of security j, and k m = the return on the market index. The CAPM equation:  

12. Example: AT&T 6 ½ 36  Par value = $1,000  Coupon = 6.5% or par value per year, or $65 per year ($32.50 every six months).  Maturity = 28 years (matures in 2036)  Issued by AT&T. 0 12… 28 $32.50 $32.50 $32.50 $32.50 $32.50 $32.50+$1000

13. Types of Bonds  Debentures  Subordinated debentures  Mortgage bonds  Zeros  Junk bonds  Eurobond

14. Definitions  Bond indenture and rating  Current yield  Book value  Liquidation value  Market value  Intrinsic value

15. Bond Valuation V b = $I t (PVIFA k b, n ) + $M (PVIF k b, n ) $I t $M (1 + k b ) t (1 + k b ) n V b = + n t = 1 

16. The Financial Pages: Corporate Bonds Cur Net Yld Vol Close Chg Polaroid 11 1 / 2 13 19.3 395 59 3 / 4...

17. Five Relationships  Value of bond is inversely related to changes in the investor’s present required rate of return  Market value of bond will be less than the par value if investor’s required rate is above the coupon interest rate

18. Five Relationships  As maturity date approaches, the market value of bond approaches its par value  Long-term bonds have greater interest rate risk than do short-term bonds

19. Five Relationships  The sensitivity of bond’s value to changing interest rate depends not only on length of time to maturity, but also on the pattern of cash flows provided by the bond  Duration (calculation and conclusion)

20. Preferred Stock  Definition and features (similarities with bond and stock, dividend cumulative…)  Valuation V = D k ps

21. Common Stock  Definition and features  Valuation 1. discounted dividend and selling price of the stock 1. discounted dividend and selling price of the stock 2. 2. V cs = D 1 k cs - g

22. Growth Rate  g = ROE * r  g: the growth rate of the company  ROE: return on equity  r: the company’s percentage of profit retained