Test Bank for Foundations of Finance 10e 10th Edition by Arthur J. Keown, John D. Martin;, Exams of Financial Management

Download Test Bank for Foundations of Finance 10e 10th Edition by Arthur J. Keown, John D. Martin; and more Exams Financial Management in PDF only on Docsity! Foundations of Finance 10th Edition by Arthur J. Keown, John D. Martin; J. William Petty Finance - Correct answer-Making decisions that add value by focusing on cash flows' timing, risk, and magnitude. Intrinsic Value - Correct answer-The true worth of something today, as defined by Warren E. Buffett. Value vs. Price - Correct answer-Value is what something is worth, while price is what it costs to obtain. Determining Value - Correct answer-Process of valuing any financial asset by considering cash flows between now and Judgment Day, discounted at the proper rate of interest. Present Value - Correct answer-Current value of future cash flows discounted at an appropriate rate. Personal Finance - Correct answer-Financial decisions specific to an individual or family's situation. Corporate Finance - Correct answer-Financial decisions made by managers in running businesses or corporations. Public Finance - Correct answer-Financial policies implemented by governments to meet social and fiscal responsibilities. Investment Finance - Correct answer-Actively valuing investment opportunities like stocks and bonds, including mutual funds and hedge funds. Finance in the movies - Correct answer-Portrays criminals or individuals consumed by greed, giving a twisted view of finance. Corporate finance - Correct answer-Involves being the finance leader in a team, influencing decisions on operations and capital budgeting. Investments - Correct answer-Involves performing detailed analysis on companies for investment recommendations. Personal finance - Correct answer-Involves understanding client needs and helping them make sound financial decisions. Decision making in finance - Correct answer-Involves making choices that create value and impact valuation. Risk and return tradeoffs - Correct answer-Involves evaluating the balance between risk and return in financial decisions. Quantitative methods in finance - Correct answer-Involve using numerical techniques for risk, return, valuation, and analyses. Skills in finance - Correct answer-Include being detail-oriented, analytical, logical, and having interpersonal skills. Ethical and moral foundation in finance - Correct answer-Necessary for serving clients, shareholders, and capital markets. Financial Analyst - Correct answer-Job title in corporate finance involving financial analysis and decision- making. Chartered Financial Analyst (CFA) - Correct answer-Credential for professionals in investments, demonstrating expertise in investment analysis. Treasury notes (1-10 year maturity) Treasury bonds (10-30 year maturity) Semi annual coupon payments Pays 5% interest US GDP and debt as share of GDP - Correct answer-17 trillion and 105% Municipal bonds - Correct answer-Issued by state and local governments (3.7 trillion) Exempt from federal income tax and state local tax General obligation bond (municipal) - Correct answer-Municipal bond backed by the full faith of credit of the issuer (taxing power) Pays 4% interest Revenue bond - Correct answer-Issued to finance specific projects (riskier) Corporate bonds - Correct answer-4.5 trillion (non financial) Default risk - become very worried about this Commercial paper - borrow short term (90 days) Corporate bonds (longer term, typically semi annual payments, different seniority classes, including senior and junior) Equity - Correct answer-Ownership in a firm Future cash flows (dividends are uncertain) Maturity is indefinite Involves risk, variable liquidity Valuation: TVM + risk adjustment How many classes of equities - Correct answer-Common stock: voting rights (junior) Preferred stock: non-voting but more senior when bankruptcy Derivatives - Correct answer-Securities whose cash flow depends on the value of other assets Options, futures, swaps, bonds with option feature Valuation: TVM+risk+option adjustment Mutual funds - Correct answer-Financial intermediaries that pool funds from investors and buy assets (active management) Need to pay a high fee Exchange traded funds (ETF) - Correct answer-Mostly passive and competition of mutual funds Asset backed securities - Correct answer-Bundling of existing securities such as mortgages, auto loans, corporate bonds Securitization - Correct answer-Example of financial engineering Financial markets - Correct answer-Platform on which financial assets are traded Primary markets - Correct answer-Where sold to first investors Raises capital How securities are floated (sold) Government securities vs corporate securities - Correct answer-Government securities are auctioned, corporate securities are underwritten by investment banks Primary markets for equity - Correct answer-Typically best effort Book building Road show Filing for an IPO (register with SEC, S-1 filing, approved: prospectus) Secondary markets - Correct answer-Investors usually deal through brokers Broker guarantees counterparty that: -an investor can pay for the security he is buying -an investor can deliver a security he is selling Online brokers - Correct answer-Charles Schwab, e-trade Broker trades - Correct answer-Limit order Market order Stop loss order Limit order - Correct answer-I want to buy but there is a limit I am willing to pay Market order - Correct answer-I want buy no matter the price Stop-loss order - Correct answer-Sell when it drops below $X Stop buy order - Correct answer-Buy when it hits price How do brokers trade? - Correct answer-Traditional floor trading and electronic trading (NYSE) -marched by Designated Market Makers (DMM) (no inventory) Dealer Markets (Nasdaq) Yield to maturity for a bond - Correct answer-At what rate does $PV grow up to $FV in a span of T years R=(FV/PV)^(1/T)-1 Single payment security - zero coupon bond - Correct answer-Fixed income that pays face value at maturity but no intermediate interest payments Lower interest rates = higher bond prices Pull to par - Correct answer-The increase in value as the bond approaches maturity Pricing of single payment securities (zero coupon bond) - Correct answer-Price = PV = FV / (1+R)^T Do longer maturity zeros have greater percentage price volatility than shorter zeros for the same change in interest rates? - Correct answer-Yes Annuity - Correct answer-PV = C/(1+R)+C/(1+R)^2 ... + C/(1+R)^T PV = C ( (1-1/(1+R)^T ) / R) Pays a fixed cash flow C for T periods Perpetuity - Correct answer-Pays a fixed cash flow, C, for every period forever PV=C/R Objectives and instruments of the Fed - Correct answer-Objectives: full employment and stable prices Instrument: interest rate Federal funds rate - Correct answer-Rate at which banks can borrow from the Fed Monetary policy - Correct answer-If rate is lower, banks will be willing to lend at lower rates to households and firms. Households will consumer more and firms will invest more, reducing unemployment As people want to buy more things, the price of things goes up (and inflation increases) Quantitative easing - Correct answer-Rather than reduce the cost of borrowing of banks and hope that they will reduce the borrowing cost of households and firms, the central bank will lend more directly. Buying back mortgage backed securities - if banks know Fed will buy them, will be more likely to make mortgage loans Annual Percentage Rate (APR) - Correct answer-Required by law Quoted rate Interest per period * number of periods per year Does not take compounding into account True cost of credit - Correct answer-Effective annual rate If interest is compounded m times a year EAR= (1+quoted rate / m)^m - 1 Quoted rate = APR Continuous compounding EAR - Correct answer-Exp(quoted rate) - 1 e^ on calc Continuous compounding formula - Correct answer-Pe^(rt)=F Present Holding period yield - Correct answer-When a bond is sold prior to maturity (annual return) Yield to maturity - Correct answer-YTM = (F/P)^(1/t)-1 T years to maturity Annual compounding F = face amount P = price Annual return - Correct answer-(V'/V)^(1/T)-1 V' = value at the end V= value at beginning Holding period return - Correct answer-V(T)/V(0)-1 Doesn't take time into account Annual holding period return - Correct answer-((V(T)/V(0))^(1/T) - 1 Random Variable - Correct answer-A variable whose value depends uniquely on the outcome of an experiment Probability distribution - Correct answer-The likelihood of each possible event Two features of portfolio weights - Correct answer--sum to 1 -negative weight equals a short position Portfolio variance - Correct answer-Var [Rp] = w1^2SD^2 + w2^2SD^2+2w1w2(corr)(SD1)(SD2) Diversification - two risky securities - Correct answer-Truly a free lunch Less risk than either one Higher return than the lower-return security Gains of diversification depend on the degree of correlation between the asset returns Even a positive correlation helps to reduce risk of a portfolio Investment opportunity set - Correct answer-Consists of all available risk-return combinations Efficient portfolio - Correct answer-Portfolio that has the highest possible expected return for a given standard deviation Efficient frontier - Correct answer-Set of efficient portfolios. It is the upper portion of the minimum variance frontier starting st the minimum variance portfolio Minimum variance portfolio - Correct answer-Portfolio that provides the lowest variance (standard deviation) among all possible portfolios of risky assets No gains from diversification - Correct answer-If correlation equals 1 Maximal gains from diversification - Correct answer-Correlation =-1 What portfolio should an investor choose? - Correct answer-Should choose an efficient portfolio but which is optimal depends on risk aversion Investors optimally trade off risk and return to - Correct answer-Maximize their expected utility Mean variance utility - Correct answer-U(Rp)=E(Rp)-0.5AVar(Rp) Asset allocation makes up what percent of portfolio performance - Correct answer-94% The risk free return is known for sure - Correct answer-Expected return = R(f) Standard deviation = 0 Correlation is 0 for any other asset Risk free returns - treasury bills - Correct answer-Less than 1 year Key risks for treasuries - Correct answer-Interest rate risk and default risk Most risk less asset - Correct answer-Cash - still has inflation risk One risk free and one risky asset - Correct answer-Return: R(f) + w*E[Ri-Rf] Variance of portfolio = w^2*SD^2 Standard deviation |w|SD Capital allocation line - Correct answer-R(f) + (Sharp ratio of i)SD E(Rp)=Rf+E(Rm-Rf)/(SDm)*SD Capital market line - Correct answer-Risk return combinations achieved by forming portfolios from the risk free security and market portfolio Sharp ratio - Correct answer-Measure risk adjusted performance E[Ri-Rf]/SD Calculated by subtracting the risk free rate rate of return for a risky asset and dividing he result by the standard deviation of risky returns Return per unit of risk Efficiency frontier for two risky and one risk free asset - Correct answer-Rf , MVE (mean variance efficient), where MVE is the tangency portfolio of the old efficient frontier and the straight line through Rf with the highest sharpe rati Feasible - Correct answer-Combinations of assets: principles of diversification -Investment opportunity set -Efficient frontier Insurance principle - Correct answer-If add lots of uncorrelated assets, the risk is diversified away Risk in equally weighted portfolios - Correct answer-Variance of portfolio return = average covariance of returns as N goes to infinity No diversifiable risk financial instruments include - Correct answer-equity, debt, derivates (futures, forwards, options, swaps), hybrids Financial markets role - Correct answer-provides a forum for the creation and exchange of financial instruments - allocative role involves efficiently distributing scares funds between competing uses. financial market advantages - Correct answer-the cost of intermediation is avoided, increase access to a diverse range of markets provides greater flexibility in the range of securities that deficit units can issue for different financing needs financial market disadvantages - Correct answer-matching of preferences may be difficult, liquidity and marketability of securities is dependent upon the other party, search and transaction costs may be high, assessments of risk can be difficult Direct Financial market - primary markets - Correct answer-markets where investors purchase financial securities from the original issuer. this market takes place through an initial public offering (IPO) of shares to the public or through a private placement Direct Financial market - secondary market - Correct answer-markets where investors trade their securities with other investors. Secondary markets are where previously issued financial claims are exchanged among investors Money markets - Correct answer-markets for short-term (less than 12 months) financial instruments - e.g. bank bills capital markets - Correct answer-markets for long -term (12 months of greater) financial instruments - e.g. shares wholesale market - Correct answer-markets where financial flow transactions occur directly between institutional investors and borrowers, this involves larger transaction retail market - Correct answer-market where transactions are conducted primarily with financial intermediaries by the household and small to medium sized business sectors; this involves smaller transactions issuing and trading financial securities can be issued through - Correct answer-public offering: securities are issued to the general public private placement: securities are issued to a single investor or group. This is the simplest method of transferring funds between savers and borrowers liquidity of financial market - Correct answer-refers to the ease of buying and selling without undue price fluctuations market participants who add liquidity - Correct answer-market-makers, speculators, arbitrators Reserve Bank of Australia - Correct answer-responsible for monetary policy, the payment system and the stability of the entire financial system - not directly under the authority of the government (independent from the government) RBA - monetary policy - Correct answer-management of short term interest rates with the objective including maintenances of: - a stable Australian currency - full employment - prosperity and welfare of the Australian people - target of 2-3% inflation per annum The Australian Prudential regulation authority - Correct answer-is responsible for prudential supervision of financial institutions roles of the Australian Prudential regulatory authority - Correct answer-maintain investors confidence, avoid contagion, ensure the stability of the financial system The Australian securities and investment commission - Correct answer-responsible for the enforcement of company and financial service laws. Objective is to protect consumers, investors and creditors responsible for licensing and monitoring financial markets and advisors and monitoring disclosure and conduct of Australian companies and service providers functions of the Australian securities and investment commission - Correct answer-assist and protect retail investors and consumers in the financial economy. build confidence in the integrity of Australia's capital markets Annuities - Correct answer-payments of equal amounts of cash at regular intervals of time over serval time periods Perpetuities - Correct answer-involves equally spaced cash flow of equal amounts lasting forever compounding - Correct answer-interest calculated on the initial principal and also on the accumulated interest of previous periods of deposit or loan time value of money - Correct answer-when converting money across the future it is important to remember that one today is worth less so its price reflects a discount Annual percentage (APR) - simple interest - Correct answer-indicates the amount of interest earned in one year without the effect of compounding - however, it does not reflect the true amount you will earn and this cannot be used as the discount rate ordinary annuities - Correct answer-structured so that cash payments made or received at the end of each period annuities due - Correct answer-cash payments made or received at the beginning of each period deferred annuities - Correct answer-annuities that don't start in the first period of the given timeline equivalent annuities - Correct answer-the ordinary annuity formula is also used to evaluate projects with unequal lives listed PUTs - Correct answer-listed on the ASX and are highly liquid because units can be easily traded via the exchange at the current market prices unlisted PUTs - Correct answer-units are purchased via prospectus at a price determined by a formula based on valuation of the funds assets hedge funds - Correct answer-involve a high degree of leverage. It is when investors pool their money which is then invested into a variety of asset by the fund manager. The hedges (reduces) risks associated with variability of the individual asset classes advantages of the hedge fund - Correct answer-investments are professionally managed, investors gain access to a wide menu of assets types, enhance liquidity disadvantages of the hedge fund - Correct answer-fund mangers can exhibit short - termism and herb behaviour, the investor faces the principal - agent problems, the investors incurs the high cost of fees superannuation fund - Correct answer-set up as an indefinitely continuing fund - to provide retirement and death benefits to members superannuation issues to consider - Correct answer-taxation benefits, contributions, DIY superannuation funds types of superannuation funds - Correct answer-defined contribution funds, defined benefit funds, industry funds, public sector funds, corporate funds, retail funds, self managed superannuation defined contribution funds (superannuation fund) - Correct answer-pay a benefit determined by the funds performance: investment risk is borne by the member defined benefit funds (superannuation funds) - Correct answer-have a pre-determined final payout: investment risk is borne by the employer industry funds (superannuation funds) - Correct answer-often restrict to employees in a particular industry although some larger funds are open for anyone to join public sector funds (superannuation funds) - Correct answer-were created for employees of federal and state government department and most are only open to government employees corporate funds (superannuation funds) - Correct answer-are arranged by employers for their employees. retail funds (superannuation funds) - Correct answer-accept contributions from individuals in general and are run by banks or investment companies self managed superannuation - Correct answer-these funds have fewer than five members and are controlled by the funds trustee(s). amortisation (loan) - Correct answer-describes how the principal amount borrowed is repaid over the life of the loan. with an amortisation loan each repayment is divided into two portions - one portions represent the reduction in the principal with the other portion indicates the interest payment. Is influenced by the RBA Main types of interest rates - Correct answer-variable rate fixed rate introductory or honeymoon rate variable rate - Correct answer-the interest rate goes up or down in response to changes in the cash rate and other changes by the credit provider fixed rate - Correct answer-a fixed rate allows borrowers to lock in an interest rate on their loan - typically for 1 to 5 years introductory or honeymoon rate - Correct answer-some credit providers offer low interest rates for the first 1 or 2 years of loan. before taking up this option, it is important to find out what the interest rate will be when the period ends mortgage finance - Correct answer-a form of security loan - not the actual loan itself. The borrower conveys interest in the land to the lender through a mortgage placed on the land title itself users of mortgage financing - Correct answer-mortgage finance accounts for $2 trillion ASX market capitalizations, mortgage finance in Australia mainly takes the form of retail home loan with up to 30 years terms Mortgage providers - Correct answer-commercial banks, building societies, life insurance offices, superannuation funds, trustee institutions, finance companies, mortgage originators Risks involves with mortgages - Correct answer-the mortgagee (lender) may reduce the risk of borrowers defaulting by requiring the mortgagor to take out mortgage insurance up to 100% value of the mortgage securitisation and mortgage finance - Correct answer-the conversion of non-liquid assets into new asset- backed securities that are serviced with cash flows from the original asset - the process of securitization effectively removes the home loans from the originators balance sheet Financial institutions in Australia - Correct answer-authorised deposit taking institutions (ADIs), Non- ADIs financial institutions, fund managers, insurers Banks - Correct answer-the heart of banking is at accept deposits and make loan - nowadays, they also run payments systems and trade securities retail banking (banking) - Correct answer-involves small transactions, with the household sector being the main participant and suburban branches playing an important role wholesale banking - Correct answer-involves large transactions, most often made by corporate sector and is more often conducted in a city location Banks perform a number of goods and services to help assist the efficiency of the economy including - Correct answer-denomination transformation, maturity transformation, liquidity creation credit risks - Correct answer-risk of loan defaults - to cover the losses when loans are not repaid or have become non-performing interest rate risks - Correct answer-because of increased interest rate volatility - interest rates must be measured and controlled so that banks ensure they earn a spread between its borrowing rates and rates it can earn on investments Non bank financial systems - Correct answer-building societies, credit unions, financial companies building societies - Correct answer-focus on making mortgage loans. Main asset consists of residential mortgages, capital is raised by members, profit is accumulated rather than paid out in dividends, main source of income is interest income credit unions - Correct answer-short term customer loans, assets mainly consist of loans to members, liabilities mainly come from member saving accounts, capital mainly consists or retained earnings as they do not hold shareholders equity Financial companies - Correct answer-Not AIDs, specialise in consumer finance and leasing, also deal with the same products as banks etc. money markets - Correct answer-collection of markets each trading different short term financial securities OTC Money market instruments - Correct answer-short term maturity, low default risk, high marketability/ liquidity, large denominations, low per dollar transaction costs role of money markets - Correct answer-wholesale market trades more than $1 million, open market transactions because of impersonal and competitive nature, settlements take place in Austraclear, provides economic way for economic units to undertake liquidity management Types of money markets - Correct answer-Treasury bills, commercial paper, deposits, repurchase agreements money markets capital structure - Correct answer-refers to how a company funds its operations. two components: - DEBT = money borrowed by issuing short term instruments - EQUITY = money which belongs to the company usually provided by shareholder Treasury Notes - Correct answer-Auctioned by the Australian office of financial management - less that one year maturity Repurchase agreements - Correct answer-an agreement involving the sale of a security with the condition that the seller will buy it back at a predetermined price, don't last longer than a wee Purpose of repos - Correct answer-to provides cheap funding source, place to keep short term surplus cash, way to alter a portfolio risk, means to cover short-term liquidity shortfalls commercial paper - Correct answer-issued as an alternative to borrowing from a bank and can sell it through an underwritten or non underwritten offer Commercial paper underwritten or non- underwritten - Correct answer-underwriting guarantees the issue will be taken up by investors, non underwritten issues are cheaper for the firm because commissions are not paid to an underwriter Negotiable certificates - Correct answer-a bank term that is negotiable, designed by banks to attract large corporations to deposit. Secondary market means that CDs can be bought and sold at any time Bank accepted bills - Correct answer-a bank draft drawn on and accepted by a commercial bank - the bank promises to pay the holder of the bill its face value at maturity Bond market - Correct answer-as loan from an investor to a corporation or government which is then agreed to be paid back after a certain time period when the debt reaches maturity participants in the bond market - Correct answer-brings together borrowers and suppliers for long-term funds. Largest purchaser are individuals and households, largest issuer are the commonwealth and state government commonwealth government securities - Correct answer-treasury bonds and notes backed by credit of the commonwealth government. The treasury bonds are coupons whereas treasury notes are discount securities Characteristics of CGS - Correct answer-considered default risk free, new issues are 5 and 13 year maturities, insurance process is conducted by the RBA corporate bonds - Correct answer-issued by companies and represents debt contracts requiring payment of interest periodically and repayment of principal at maturity - can be either unsecured notes or debentures bond characteristics - Correct answer-collateral sunk funds provision convertible bond credit wrapping offshore bonds securitisation collateral bonds - Correct answer-unsecured notes have no specified collateral attached to the bond, debentures are secured by specific assets of the corporation sunk fun provision (bonds) - Correct answer-requires corporations to place funds with a trustee to retire a proportion of the debt issued each year - done by purchasing them on the market convertible bonds - Correct answer-hybrids that can be converted into equity at the shareholders discretion credit wrapping - Correct answer-issued by companies with lower credit ratings - done by companies with predictable earnings. It lowers the yield risk and return for shares - Correct answer-total risk is defined as the variability of returns on an investment over the holding period and is measured by standard deviation of the share price diversifiable risk - Correct answer-refers to risk that cannot be eliminated through spreading the portfolio market risk - Correct answer-cannot be eliminated because it is systemic capital asset pricing model (CAPM) - Correct answer-provides an explanation for the relationship between expected return on a share and its market related risk strengths and weakness of CAPM - Correct answer-strengths - simple to calculate, provides a quantifiable estimate of risk weaknesses - considerable instability estimates beta raises questions about their relevance to future risk assets defining derivatives - Correct answer-derivatives are synthetic instruments whose value derives from that of an underlying product. can be used to manage risk but also to tale more risk classifying derivatives - Correct answer-can be traded in two ways: 1. exchange trade (ET): traded on an exchange, whereby the price is determined by a competitive bidding process 2. over the counter: contracts made directly between two parties after some negotiation flexible derivatives - Correct answer-allow the holder the opportunity to gain from favourable price trend while still protecting them from unfavourable trends fixed rate derivative - Correct answer-fix the price at which future transactions is carried out - protecting the holder from losses but also precludes any windfall gains forwards - Correct answer-over the counter contracts that fix the price of a future transaction - the price of a future transaction is fixed futures - Correct answer-forward contracts traded on exchange options - Correct answer-put or call options swaps - Correct answer-two counter parties agree to exchange one stream of cash flows against another stream forward rate agreements - Correct answer-OTC interest rate derivatives with the following characteristics: 1. two parties agree to guarantee each other a given interest rate at a future date 2. notional principal is used but not exchanged 3. when settlement date arrives one party compensates the other they are used because they guarantee the cost of funds to buyer and earns fees for the bank purpose of swaps - Correct answer-allow a stream of fixed interest rate payments to be exchanged for one of variable interest rate payments - can be used to reduce cost of funds, notional principal is used but not exchanged ways to use swaps - Correct answer-to hedge interest rate exposure to gain a comparative advantage for yield pick - up futures characteristics - Correct answer-price of forward is determined by a competitive bidding process, parties make contracts with a clearing house but not each other. this fund is guarantee use of futures - Correct answer-1. to guarantee cost of funds 2. to reduce systematic risk 3. to arbitrage 4. to leverage advantages and disadvantages of futures - Correct answer-ADVANTAGES: futures provide more liquidity, credit risk is lower as it is covered by the clearinghouse DISADVANTAGES: lack customisation (major advantage of forwards), include cash flow intrusion of margin calls, limited range of contracts margin calls - Correct answer-margin is a deposit when ensures the completion of the contract Call options - Correct answer-give the holder the right (but not obligation) to buy the underlying security at the strike price Put options - Correct answer-give the holder the right (but not obligation) to sell the underlying security at the strike price strike prices - Correct answer-the price at which the physical security can be bought/sold when the option expires premium prices - Correct answer-purchase price of the option contract option buyer - Correct answer-purchases the contract, keeps the contract premium but takes on an obligation (has limited risk and unlimited profit potential) -long call and long put option writer - Correct answer-sells the contract, keeps the contract premium but takes on an obligation - short call and short put types of options and their uses - Correct answer-American options are options that can be exercised at any time up until their expiry date European options are options that can be exercised only on the expire date