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Level 119

Property & Pricing of Financial Assets


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What are the 11 properties of financial assets?
(1) moneyness, (2) divisibility and denomination, (3) reversibility, (4) cashflow, (5) term to maturity, (6) convertibility, (7) currency, (8) liquidity, (9) return predictability, (10) complexity, and (11) tax status
Moneyness
some financial asset used as a medium of exchange or in settlement of transactions. Could be cash or near money, such as time & savings deposits and Treasury Bills.
Divisibility
relates to the minimum size in which a financial asset can be liquidated and exchanged for money. The smaller, the more divisible.
Reversibility, or turnaround cost, or round-trip cost
the cost of investing in a financial asset and then getting out of it and back into cash again.
Bid ask spread
the most relevant component of round-trip cost, which might be added commissions and the time and cost, if any, of delivering the asset.
Thickness of the market
the prevailing rate at which buying and selling orders reach the market. That is, the frequency of transactions.
Thin Market
one that has few trades on a regular or continuing basis.
Nominal expected return
the net real expected return after adjustment for the loss of purchasing power (due to inflation)
Term to maturity
the length of the period until the date at which the instrument is scheduled to make its final payment, or the owner is entitled to demand liquidation.
Perpetual, or consul
In the U.K. this is a bond that promises to pay a fixed amount per year indefinitely and not to repay the principal at any time.
Call provision
a provision that entitles the corporation to repurchase its preferred stock from investors at stated prices over specified periods.
Put Option
selling shares
Convertible (convertibility)
important property of assets which converts from one asset class to another, such as a convertible bond, or within a class (bond converted to another bond).
Return predictability
assuming investors are risk averse, the riskiness of an asset can be equated with the uncertainty or unpredictability of its return.
Callable Bond
give the firm the option to repurchase the bond from the holder at a stipulated call price
Putable bond
a bond that can be sold back to the issuer at a fixed price
present value
comparison of the anticipated cash flow from an investment to the initial investment
Discount Rate (r)
is the return that the market or consensus of investors requires on the asset
What is the convenient (but approximate) expression (formula) for the appropriate discount rate?
r = RR + IP + DP + MP + LP + EP
What is RR in the discount rate formula?
Real Rate of interest. It is the reward for not consuming and for lending to other users
What is the IP in the discount rate formula?
Inflation Premium. The compensation for the expected decline in the purchasing power of the money lent to the borrowers.
What is the DP in the discount rate formula?
Default Risk Premium. The reward for taking on the risk of default in the case of a loan or bond or the risk of loss of principal for other assets
What is the MP in the discount rate formula?
Maturity Premium. The compensation for lending money for long periods of time
What is the LP in the discount rate formula?
Liquidity Premium. The reward for investing in an asset that may not be readily converted to cash at a fair market value.
What is the EP in the discount rate formula?
Exchange-rate risk premium. The reward for investing in an asset that is not denominated by the investor's home currency.
What is the formula to computer the after-tax discount rate?
pretax discount rate * (1 - marginal tax rate).
deceases Present Value. It is inversely related.
Increase in yield does what to the PV?
basis point
1/100 of a percent
What is the effect of longer maturity?
The longer the maturity = the greater the price sensitivity
Zero-coupon bond
A bond with no coupon rate. The investor who purchases one receives no periodic interest payment. Instead, the investor purchases it at a price below its principal and receive the principal at the maturity date.
What is an expression for duration related to the price sensitivity
Approximate percentage change in a financial asset's price = - Duration * (yield change in decimal form) * 100
duration
same as interest rate risk
Modified Duration
If the yield on a bond is measured with other compounding frequency
Effective Duration
Measures the sensitivity of a bond's price to parallel shifts in the benchmark yield curve.
Macaulay Duration
If the yield on a bond is measured with continuous compounding