## Introduction

Finance is such an important part of modern life that almost everyone can benefit from understanding it better. What you may find surprising is that the financial problems facing PepsiCo or Microsoft are not really different from those facing an average investor, small business owner, entrepreneur, or family. On the most basic level, these problems are about how to allocate money. The choices are many money can be borrowed, saved, or lent. Money can be invested into projects. Projects can be...

## Info

A bubble is a run-away market, in which rationality has temporarily disappeared. There is a lot of debate as to whether bubbles in the stock market ever occurred. A strong case can be made that technology stocks experienced a bubble from around f 998 to 2000. It is often called the dot-com bubble, the internet bubble, or simply the tech bubble. There is no convincing explanation based on fundamentals that can explain both why the Nasdaq Index had climbed from 2,280 in March i999 to 5,000 on...

## End of Chapter Problems

Q6.28 Is this morning's CNN forecast of tomorrow's temperature a random variable Is tomorrow's temperature a random variable Q 6.29 Does a higher reward (expected rate of return) always come with more risk Q6.30 Is the average individual in a betting pool effectively more, equally, or less risk-averse than the overall pool Q 6.31 A financial instrument will pay off as follows Probability 50 25 12.5 6.25 3.125 3.125 Payoff 100 110 130 170 250 500 (a) What price today would make this a fair bet...

## C

Ed Altman (from New York University) collected corporate bond statistics from 1971 to 2003. Figure 6.2 gives a sketch of how likely default (defined as missing at least one coupon payment) was for a given credit rating High-Quality Borrowers Very few investment grade bonds default and especially right after issue when they still carry the original credit rating. The probability of default is less than 3 in total over a 10-year horizon (0.3 per annum). Low-Quality Borrowers In an average year,...

## Annuities

The second type of cash flow stream that lends itself to a quick formula is an annuity, which An Annuity pays the is a stream of equal cash flows for a given number of periods. Unlike a perpetuity, payments same amount for T stop after T periods. For example, if the interest rate is 10 per period, what is the value of an years' annuity that pays 5 per period for 3 periods Let us first do this the slow way. You can hand-compute the net present value to be PV + 55 + 55 S12 4343 1.10 1.102 + L103...

## Credit Ratings and Default Rates

The Rating Agencies the most important are Moody's and Standard& Poor's. The Ratings most important is junk vs. investment grade. To make it easier for lenders to judge the probability of default, a number of data vendors for credit-ratings have appeared. For individuals, Experian and Dun& Bradstreet provide credit-ratings you should request one for yourself if you have never seen one. For corporations, the two biggest credit rating agencies are Moody's and Standard& Poor's. (There are...

## Side Note

Most mortgages are fixed rate mortgage loans, and they are basically annuities. They promise a specified stream of equal cash payments each month to a lender. A 30-year mortgage with monthly payments is really a 360-payments annuity. (The annu-ity formula should really be called a month-ity formula in this case.) What would be your monthly payment if you took out a 30-year mortgage loan for S500,000 at a quoted interest rate of 7.5 per annum Before you can proceed further, you need to know one...

## End of Main Chapter Problems

Q 3.25 A tall Starbucks coffee costs 1.65 a day. If the bank's quoted interest rate is 6 per annum, compounded daily, and if the Starbucks price never changed, what would an endless, inheritable free subscription to Starbucks coffee be worth today Q 3.26 If you could pay for your mortgage forever, how much would you have to pay per month for a 1,000,000 mortgage, at a 6.5 annual interest rate Work out an answer change if the 6.5 is a bank quote and one if it is a true interest rate Q 3.27 What...

## Summary

The chapter covered the following major points gt - Figure 7.4 showed an analysis of historical rate-of-return patterns of investments in cash, bonds, stock indexes, and individual stocks. Stocks, on average, had higher average rates of return than bonds, which in turn had higher average rates of return than cash investments. Individual stocks were most risky. Large stock market portfolios had lower risk than individual stock holdings. Bonds had lower risk yet, and cash was least risky. gt -...

## The Security Market Line SML

An example of what rate of returns individual securities should offer. The Security Market Line, or SML, is just the CAPM formula. The Security Market Line in an Ideal CAPM World Let's apply the CAPM in a specific example. Assume that the risk-free rate is 3 per year, and that the stock market offers an expected rate of return of 8 per year. The CAPM formula then states that a stock with a beta of 1 should offer an expected rate of return of 3 8 -3 -1 8 per year that a stock with a beta of 0...

## The Capital Asset Pricing Model

Market Betas Based on Economic Intuition If you really cannot think of a good publicly traded firm that you trust to be a good comparable, you may have to rely more heavily on your judgment. Think about how the rate of return of your project is likely to covary with the stock market. If you can make such a judgment, you can rearrange the CAPM Formula to obtain a beta estimate The right side of this formula helps translate your intuition into a beta estimate. You can ask such questions as What...