Firm’s financing – Debt + Equity
Debt securities are promises to repay borrowed funds, while giving fixed payment in the process.
Capital Markets refer to markets for longer-term debt securities and equity securities that have no specific maturity date. Capital market instruments used for market trade include stocks and bonds, treasury bills, foreign exchange, fixed deposits, debentures, etc. As they involve debts and equity securities, the instruments are also called securities, and the market is referred to as securities market.
NPV – Net Present Value – Present value of expected future cash flows, minus initial cost of investment. if > 0, take the project. the excess is what flows over to the shareholder.
IRR – Internal Rate of Return. Percentage that equates the PV of all cash inflows to PV of all cash outflows. IRR is the rate that makes NPV = 0.
If IRR of project > project’s expected rate of return, take the project. That would mean NPV is > 0 too. If there are 2 project with IRR > expected rate of return, and they are mutually exclusive (if undertake one then the other must be foregone), then take the one that gives the biggest NPV.
Money weighted return = IRR of the portfolio
Time weighted return = geometric mean of subperiod returns.
Yield to Maturity (YTM) = IRR on a bond. For the most common kind, YTM is 2 * semi annual IRR, since bonds commonly pays semi annual coupons.
Bond Equivalent Yield = Holding period yield (365/days)
- Financial Risks
- Credit risk is the uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations.
- Liquidity risk is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset
- Market risk is the uncertainty about market prices of assets and interest rates.
- Non-Financial Risks – Operational / Solvency / Regulatroy / Accounting risks/
Tail risk – uncertainty about probability of extreme negative outcomes. Commonly used measure include Value at Risk (VaR) – minimum loss over a period that will occur with a specific probability.
For VaR, there are 2 methods of risk assessment –
- Stress Testing – effects of a specific (usually extreme) change in a key variable; or
- Scenario analysis – what-if analysis of expected loss but incorporates specific changes in multiple inputs.
Total risk = Systematic (cannot be diversified away) (“beta”) + Unsystematic risk (Can be diversified away).
Strategic asset allocation – specifies the percentage allocations to the included asset classes. In choosing asset classes for an account, the correlations of returns within an asset class should be relatively high, and the correlations of returns between asset classes should be relatively low in comparison.