Final Study Guide Essay

Chapter 11: Stock Valuation and Risk

Stocks are commonly valued using the price-earnings (PE) method, the dividend discount model, or the free cash flow model
PE Method applies the industry PE ratio to the firm’s earnings to derive its value
Dividend Discount Model estimates the value as the present value of expected future dividends
Free Cash Flow Model is based on the present value of future cash flows a required rate of return must be estimated - apply CAPM in which the required return depends on the risk-free interest rate and the firm’s beta
Stock prices are affected by those factors that affect future cash flows ot the required rate of return by investors
Economic conditions, market conditions and firm-specific conditions can affect a firm’s cash flow or the required rate of return
The risk of a stock is measured by its volatility, its beta, or its value-at-risk estimate.
Investors are giving more attention to risk measurement in light of abrupt downturns in prices of some stocks in recent years
Stock market efficiency implies that stock prices reflect all available information
Weak-form efficiency suggests that security prices reflect all available information, such as historical security price movements and the volume of securities trades
Semistrong-form efficiency suggests that security prices fully reflect all public information
Strong-form efficiency suggests that security prices fully reflect all information, including private or insider information
Evidence supports weak-form efficiency to a degree, but there is less support for semistrong- or strong-form efficiency

Systematic Risk: risk that results from exposure to general stock market movements
Value at risk: a measurement that estimates the largest expected loss to a particular investment position for a specified confidence level
Sharpe Index: total reward-to-variability ratio
Treynor Index: risk adjusted returns relying on beta

Chapter 13: Financial Futures Market

Financial Futures Contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date
Commercial banks, savings institutions, bond mutual funds, pension funds, and insurance companies trade interest rate futures contracts to hedge their exposure to interest rate risk
Some stock mutual funds, pension funds, and insurance companies trade stock index futures to hedge their exposure to adverse stock market movements
An interest rate futures contract locks in the price to be paid for a specified debt instrument
Speculators who expect interest rates to decline can purchase interest rate futures contracts, because the market value of the underlying debt instrument should rise
Speculators who expect interest rates to rise can sell interest rate futures contracts, because the market value of the underlying debt instrument should decrease
If interest rates move in the anticipated direction, the financial institutions will gain from their futures position, which can partially offset any adverse effects on the interest rate movements on their normal operations
Speculators who expect stock prices to increase can purchase stock index futures contracts; and vice versa
Stock index futures can be sold by financial institutions that expect a temporary decline in stock prices and wish to hedge their stock portfolios
A single stock futures contract is an agreement to buy or sell a specified number of shares of a specified stock on a specified future date
It’s regulated by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commision (SEC)
Investors who expect a particular stock price to rise over time may consider buying futures on that stock. Those who expect a stock’s prices to decline over time may consider selling futures contracts.
This activity is similar to selling a stock short, but single stock futures can be sold without borrowing the underlying stock from a broker

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