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Things you should know (and know how to do by the time of the second exam)

Note that problems on exams will never be exactly like problems done in class or on old
exams ± the purpose of the class is to teach you methods and critical reasoning that can
be applied to many situations.

Chapter 6 ± Interest Rates

1. 0now that people have differing consumption opportunities and time preferences
for consumption. The return an asset receives depends on its risk which is
reflected in the interest rate or discount rate that is used. 0now the terms nominal
(inflation premium included) and real (no inflation premium).
2. Interest rates depend on the supply and demand for funds. An interest rate that
you see in the Wall Street Journal will contain the real risk-free interest rate (r
star), an inflation premium, a default risk premium, a liquidity premium and a
maturity risk premium. 0now what each of these premiums is compensating
investors for. Also know the risks of investing long term versus short term.
There is more interest rate risk for long term ± not knowing what interest rates
will be in the far future, but reinvestment risk for short term investors ± if you
must reinvest frequently there is a risk that interest rates will be low when it is
time for you to reinvest.
3. Be able to use the interest rate equation to solve problems. In other words, if you
know some of the variables, be able to solve for the missing variables. 0now that
maturity risk premium usually increase with time ± in other words, a 20 year bond
is likely to have a larger maturity risk premium than an equivalent 10 year bond.
4. Be able to break down the interest rate equation into its components,
understanding which components apply to which kind of security. For example,
know that default risk and liquidity risk premiums are not added to Treasury
securities, but are added to corporate securities.
5. 0now that there is a term structure of interest rates, and that usually long term
interest rates are higher than short term rates to compensate investors for the
greater risk of investing long-term since it is harder to predict interest rates far
into the future. A normal yield curve is upward sloping.
6. 0now that the yield curve can be used to infer future interest rates.
7. 0now the other determinants of interest rates, including Federal Reserve policy,
government budget deficits and surpluses, international factors, and business
conditions.
8. Understand and apply basic economic theory of supply and demand as it relates to
interest rates (for example, if there is more demand for money, interest rates are
likely to rise). Understand what factors influence supply and demand; for
example, what happens if Americans save more or less? What happens to interest
rates in recessions? What happens if inflation increases or decreases?
9. 0now what shapes the yield curve can take and what implications these have for
the economy. Understand the characteristics of short and long term securities; for
example, when the yield curve is normal or typical, then short term rates are lower
than long term rates ± why is this so? 0now long term rates are generally more
volatile than short term rates.
10. Understand the relationship between the Treasury yield curve and corporate yield
curve; for example for any given term for a bond, a corporate bond will always
have a higher yield because it has a default risk and/or liquidity risk premium.

Chapter 7 ± Bonds and their Valuation

11. When given 4 of the five components in bond valuation (time left to maturity,
coupon payment, par value, price, yield), be able to calculate the fifth. Be able to
make adjustments if the bond is semi annual rather than annual, and calculate the
effective rate of interest on a bond. If you use a financial calculator, you will use
all five keys to solve the problem. For FV enter the face value of the bond, for
PMT enter the dollar amount of the payment. Note that if a problem gives you a
coupon rate, you will have to compute the dollar amount of the payment. For N
enters the number of years of the bond (annual payments). In a bond problem you
will either be solving for PV (price of the bond) or I% (yield of the bond). You
must either be given price to compute a yield or yield to compute a price. Note
that yield means what an equivalent bond would be earning if issued today. A
bond is equal to its par value at issue and at maturity. At any other time, if the
current interest rate (yield) is less than the coupon rate of the bond, the bond will
be selling at a premium (more than face value). If the current interest rate is
greater than the coupon rate of the bond, it will be selling at a discount (less than
face value). Most U.S. bonds pay semi-annual interest. In this case, still enter the
face value of the bond as FV, just as above. For N, enter the number of years
time 2. For I%, enter the annual interest rate divided by 2, and for payment enter
the annual payment divided by 2.
12. If a bond problem asks for yield to call, for N use the number of years until the
bond can be called (redeemed by the company). Which is more important ± yield
to maturity or yield to call? It depends on whether you think a company will call
the bonds before they are due. Most reports publish both the yield to call and
yield to maturity.
13. Calculate current yield on a bond.
14. Understand bond duration ± that a longer term, lower coupon rate bond, has a
greater duration and is more volatile. It will increase more when interest rates go
down and decrease more if interest rates go up.
15. Most important bond concept: interest rates have the greatest impact on bond
prices and there is an inverse relationship between bond prices and interest rates.
Interest rate risk is the greatest risk that bondholders face. The longer the time to
maturity and the lower the coupon interest rate, the more sensitive a bond is to
changes in interest rates. Bonds also face reinvestment rate risk, although this
generally is less of a concern since most bonds are long-term. This is why long-
term bonds are popular with retirees ± they are locking in a payment for a long,
known period of time, and they don¶t have to worry about reinvestment risk.
16. 0now why investors buy bonds (fixed income security; most bonds have
relatively low risk, especially compared to stock).
17. You should also know basic bond terminology: par value (face value, principal
amount), coupon interest rate, maturity date, call provision. Most of the time face
value is assumed to be $1,000 unless stated otherwise.
18. 0now who issues treasury, corporate, municipal and foreign bonds, and what the
differences are in terms of taxation and risk. For example, corporate bonds have
default risk while treasury bonds do not. Municipal bonds are tax exempt to
holders who live in the state where issued, so their effective interest rate is lower
than on an equivalent corporate bond.

Chapter 8 ± Risk and Rates of Return

Chapter 8 ± Risk and Rates of Return

0ey concept: Investors recognize that there is risk, and expect to be compensated for the
risk they take. Beta is the relevant measure of risk. Other risk (firm specific risk) can be
diversified away in a portfolio. We assume investors hold diversified portfolios.

1. 0now how to calculate dollar return and rate of return, and know the difference
between these - that rate of return in measured in percent, and is almost always
given as an annual rate.
2. 0now that standalone, or total risk, contains both the market and firm specific risk
of a company or portfolio. It is measured by standard deviation. You will not
need to calculate standard deviation for the exam, but you will need to do so (in
excel) for the group project.
3. All you need to know about probability distributions is that a wider dispersion
around the mean shows that there is more risk. Given the same risk, investors
will choose the investment with the higher return. Given the same return,
investors will choose less risk. This behavior shows that investors are risk averse.
4. 0now how to calculate expected return of a stock and of a portfolio
5. 0now coefficient of variation for the project (not the exam). This measure is not
used a lot in finance - we'll use beta a lot more.
6. Using the equation for the variance of a two asset portfolio, understand that as
you add securities with anything other than perfect positive correlation to a
portfolio, portfolio variance will decrease. This is because portfolio variance
contains two parts: firm specific or unique risk (represented by the individual
asset variances in the equation) and market risk, represented by the covariances or
correlations between the securities in the portfolio. As more assets are added to
the portfolio, there are exponentially more covariance terms, so ultimately, with
enough assets in the portfolio, the risk of a portfolio is defined by its covariance
terms. Market risk cannot be diversified away. With sufficient securities in
different sectors, you can create a portfolio that has only market risk, and no firm
specific or unique risk.
7. 0now examples of what is market risk and what is firm specific risk.
8. Understand that in a large enough portfolio, all the risk comes from the
covariance terms, not the variance terms. 0now that beta measures the
covariance of a portfolio or asset with the market.
9. Diversifying globally can further reduce portfolio risk because other countries'
markets are imperfectly correlated with the U.S. market.
10. Understand the theory behind beta ± that beta is a measure of market risk, and
represents relevant risk ± this is the only risk that is rewarded; in other words,
incorporated into the price of securities. Beta is the covariance of an asset with
the market, divided by the variance of the market portfolio. The relationship
between market risk and required return is graphed in the Capital Asset Pricing
Model (CAPM). The linear relationship is called the Security Market Line
(SML). Beta measures how risky your stock or portfolio is, relative to the overall
market.
11. Be able to calculate beta as the slope of a line.
12. 0now how to quantify the above relationship. This includes being able to use the
CAPM equation that return = rRF + è(rM - rRF) and understanding that a beta of 2
means that a stock is twice as risky as the market and a beta of .5 means a stock is
half as risky as the market.
13. Understand what the market risk premium (rM-rRF) is - the amount that risk-averse
investors require to induce them take on one unit of risk (and beta measures units
of risk).
14. 0now how to use CAPM to calculate whether a security is over or underpriced.
15. Understand that increased inflation expectations will increase required returns at
all levels of risk, and that changes in risk aversion change the slope of the SML
and therefore required returns.
16. Understand the limitations of the CAPM - it is the best measure we have to date,
but there it is not a perfect measure.
19. Be able to calculate portfolio beta. Be able to calculate the impact (either new
beta or new required rate of return) when one stock in a portfolio is replaced by a
higher or lower beta stock. While you will not need to calculate portfolio
standard deviation, you do need to understand and use the theory to answer
questions ± again, understand the equation for a two asset portfolio and know that
as you add stocks with anything other than a +1 correlation, then you will lower
portfolio risk.
20. Be able to use the capital asset pricing model equation to solve problems. This
includes solving for required return, beta, expected return on the market, market
risk premium or risk free rate, depending on what information is given in the
problem. This includes understanding what happens if something changes; for
example, if the risk free rate or inflation increases (decreases) then there is a
parallel shift up (down) in the security market line. This means that everything ±
risk free rate, expected market return, capital asset pricing model answer ± all
increase (decrease) by the same amount.
21. If the market risk premium (expected return on the market minus risk free rate)
increases or decreases, then the security market line shifts up or down, but you
need to make the calculations to see how much. Stocks with a beta greater than 1
will have a larger increase or decrease than stocks with a beta less than 1.
22. Be able to calculate individual stock and portfolio returns.

Chapter 9 ± Stocks and their Valuation

23. Calculate return and price of preferred stock.


24. Calculate required return and price using the dividend growth (discounted cash
flow) model. You should know how to value stocks using when there is no
growth (DIV/r), constant growth (DIV/r-g) and variable growth, when you must
calculate the growth individually in each year until the stock reaches a constant
growth. This is used when a company has a high (supernormal) growth rate for a
few years, and then settles into a constant, long term rate of growth. Note that
when using the constant growth model, a dividend or cash flow in one year gives
you a present value in the previous year¶s dollars. In other words, DIV5/r-g gives
you a stock price in year 4 dollars. Note that the constant growth model can¶t be
used when the growth rate is greater than the interest rate. This means that the
growth rate is likely not the long-term sustainable growth rate, or the discount rate
you are using is too low and not adequately accounting for the risk of the stock.
25. Understand the limitations of this model. In addition to the problem that it can¶t
be used when g>r, most companies don¶t have a single growth rate forever and
ever, as the model assumes. The model also assumes that dividends and capital
gains are growing at the same rate, which may not be the case in reality.
26. Note that the constant growth model can be rearranged, so that instead of finding
stock price, you are finding discount rate: r = DIV1/P0 + g, where DIV1 is next
period¶s dividend and P0 is today¶s stock price. This says that a stock¶s discount
rate is the sum of its dividend yield and growth rate.
27. If you know today¶s price and the company¶s growth rate, calculate the price at
some point in the future.
28. Calculate stock price when there is non-constant growth in dividends.
29. You should know the Corporate Valuation Model. This says that you can value a
company by discounting its cash flows by its WACC (weighted average cost of
capital, which will be covered in much more detail in Ch. 10). Note that the
terminal value in this calculation is a growing perpetuity, just like the constant
dividend growth model. This method gives you a total firm value. If you want to
know the value of a firm¶s equity or its price per share, you must subtract debt
from the firm total value.
30. Stock Market Equilibrium ± understand that in equilibrium, all securities lie on
the Security Market Line, in other words, they return exactly the amount they are
supposed to. You can calculate a stock¶s return, see whether it is over or
underpriced and whether a change would bring it back into equilibrium.

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