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We have some principles (or basic theories) of finance. They are 'time value of money, risk return trade off, valuation, leverage, bond prices vs. interest rates, liquidity vs. profitability, matching principle (or principle of suitability), portfolio (diversification) effect, and absence of arbitrage. Absence of arbitrage is required for market equilibrium. It suggests that no extra profit without investment can be obtained in a market in equilibrium. Now, explain the following terminologies. (1) Time value of money (2) Risk return trade off (3) Portfolio (diversification) effect Remind the 212 years of US history of returns from investment in small stock portfolio, large stock portfolio, corporate bonds, Treasury bonds, etc. Also see the following figure. Now explain risk-return trade off alluding to the historical implications. Explain what and show examples: money market instruments, fixedincome securities, equity, derivatives Introduce primary market and secondary market by explaining what kind of activities are carried out in each kind of security market. Introduce types of orders in security market. Introduce theories of term structure of interest rate and the five components of interest rate suggested by it. On DDM -1- (1) (2) (3) Suppose the current dividend is $10, the dividend growth rate is 5%, there will be 20 yearly dividends, and the appropriate discount rate is 10%. What is the value of the stock, based on the constant growth rate model? Now, think about an apparel company - Chira. At the end of recent year, the dividend paid by Chira was $2.35. Using D0 =$2.35, k = 4.75%, and g = 2%, which is supposed to continue permanently. Calculate an estimated stock value for Chira. In 2015, GTE Energy Co. (GTE) had an ROE of 10%, projected earnings per share of $4.05, and had a dividend level of $2.35. Suppose a banker's acceptance that will be paid in 80 days has a face value of $100,000. If the discount yield is 3.5%, what is the current price of the banker's acceptance? What is the bond equivalent yield on a 30-day Treasury bill that has a bank discount yield of 2.01 percent? Introduce three traditional theories of the term structure by showing what each means. Modern term structure theory takes it into account that long-term bond prices are much more sensitive to interest rate changes than short-term bonds. Modern term structure theory considers liquidity premium and a default premium. Show the final form of modern term structure theory taking all components of risks into consideration. You are buying a bond at a quoted price of $892. The bond has a 7.5 percent coupon and pays interest semiannually on February 1 and August (1) Find the clean price. (2) Find the dirty price. We can find spot interest rates in the market. We, however, cannot tell what the future interest rate will be. Instead, we can estimate future forward rates using expectations hypothesis. Now, suppose the four year, three year, two year interest rate is 12%, 9%, and 7% each. Current one year market interest rate is 5%. Answer the following questions. What is the one-year forward rate at the end of the first year ( (1) ). -2- (2) (3) What is the one-year forward rate at the end of the second year ( ( ).). What is the one-year forward rate at the end of the third year ( (4) ). Answer the following questions. (1) What is YTM (yield to maturity)? Also show that it is exactly the same as IRR (internal rate of return) (2) What is interest rate risk? (3) Explain the relationship between coupon rate, YTM and prices of bonds. (4) Identify if which (or none) of the following statement(s) is(are) wrong? Introduce Malkiel's Theorems. Suppose a bond has a Macaulay Duration of 11 years and a current yield to maturity of 8%. If the yield to maturity increases to 8.50%, what is the resulting percentage change in the price of the bond? A zero-coupon bond has a par value of $1,000 and matures in 4.5 years. The yield to maturity is 6.4 percent. What is the Macaulay duration? A bond has a Macaulay duration of 5.5, a yield to maturity of 6.1 percent, a coupon rate of 7.0 percent, and semiannual interest payments. What is the bond's modified duration? -3