What Is Expectations Theory

Expectations theory attempts to predict what short-term interest rates will be in

the future based on current long-term interest rates. The theory suggests that
an investor earns the same amount of interest by investing in two consecutive
one-year bond investments versus investing in one two-year bond today. The
theory is also known as the "unbiased expectations theory."

Let's say that the present bond market provides investors with a two-year
bond that pays an interest rate of 20% while a one-year bond pays an interest
rate of 18%. The expectations theory can be used to forecast the interest rate
of a future one-year bond.

 The first step of the calculation is to add one to the two-year bond’s
interest rate. The result is 1.2.
 The next step is to square the result or (1.2 * 1.2 = 1.44).
 Divide the result by the current one-year interest rate and add one or
((1.44 / 1.18) +1 = 1.22).
 To calculate the forecast one-year bond interest rate for the following
year, subtract one from the result or (1.22 -1 = 0.22 or 22%).

What Is Market Segmentation Theory?

Market segmentation theory is a theory that long and short-term interest rates
are not related to each other. It also states that the prevailing interest rates for
short, intermediate, and long-term bonds should be viewed separately like
items in different markets for debt securities.

Implications for Market Analysis

The yield curve is a direct result of the market segmentation theory.
Traditionally, the yield curve for bonds is drawn across all maturity length
categories, reflecting a yield relationship between short-term and long-term
interest rates. However, advocates of the market segmentation theory suggest
that examining a traditional yield curve covering all maturity lengths is a
fruitless endeavor because short-term rates are not predictive of long-term
rates.

Liquidity Preference Theory:

The Liquidity Preference Theory says that the demand for money is not to borrow
money but the desire to remain liquid. In other words, the interest rate is the 'price'
for money. John Maynard Keynes created the Liquidity Preference Theory in to
explain the role of the interest rate by the supply and demand for money. According
to Keynes, the demand for money is split up into three types – Transactionary,
Precautionary and Speculative.
He also said that money is the most liquid asset and the more quickly an asset can be
converted into cash, the more liquid it is.

1. Transactionary Demand
People prefer to be liquid for day-to-day expenses. The amount of liquidity desired
depends on the level of income, the higher the income, the more money is required for
increased spending. This is called transactionary demand.

2. Precautionary demand
Precautionary demand is the demand for liquidity to cover unforeseen expenditure such
as an accident or health emergency. The demand for this type of money increases as the
income level increases.

3. Speculative demand
Speculative demand is the demand to take advantage of future changes in the interest
rate or bond prices. According to Keynes, the higher the rate of interest, the lower the
speculative demand for money. And lower the rate of interest, the higher the speculative
demand for money.

What Is the Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks. CAPM is
widely used throughout finance for pricing risky securities and generating
expected returns for assets given the risk of those assets and cost of capital.

Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset given its risk is as
follows:

R=rf+beta(rm-rf)
Investors expect to be compensated for risk and the time value of money.
The risk-free rate in the CAPM formula accounts for the time value of money.
The other components of the CAPM formula account for the investor taking on
additional risk.

The beta of a potential investment is a measure of how much risk the

investment will add to a portfolio that looks like the market. If a stock is riskier
than the market, it will have a beta greater than one. If a stock has a beta of
less than one, the formula assumes it will reduce the risk of a portfolio.
What is the Efficient Market Hypothesis (EMH)?
The Efficient Market Hypothesis, or EMH, is an investment theory whereby
share prices reflect all information and consistent alpha generation is
impossible. Theoretically, neither technical nor fundamental analysis can
produce risk-adjusted excess returns, or alpha, consistently and only inside
information can result in outsized risk-adjusted returns.

According to the EMH, stocks always trade at their fair value on stock
exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices.

As such, it should be impossible to outperform the overall market through

expert stock selection or market timing, and the only way an investor can
possibly obtain higher returns is by purchasing riskier investments.

Tradeoff Theory of capital structure:

The trade-off theory of capital structure is the idea that a company chooses how much debt
finance and how much equity finance to use by balancing the costs and benefits. The classical
version of the hypothesis goes back to Kraus and Litzenberger[1] who considered a balance
between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency
costs are also included in the balance. This theory is often set up as a competitor theory to
the pecking order theory of capital structure. A review of the literature is provided by Frank and
Goyal.[2]
An important purpose of the theory is to explain the fact that corporations usually are financed
partly with debt and partly with equity. It states that there is an advantage to financing with debt,
the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress
including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers
demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.).
The marginal benefit of further increases in debt declines as debt increases, while the marginal
cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when
choosing how much debt and equity to use for financing.

What Is the Gordon Growth Model?

The Gordon Growth Model (GGM) is used to determine the intrinsic value of a
stock based on a future series of dividends that grow at a constant rate. It is a
popular and straightforward variant of a dividend discount model (DDM).

Given a dividend per share that is payable in one year and the assumption the
dividend grows at a constant rate in perpetuity, the model solves for the
present value of the infinite series of future dividends. Because the model
assumes a constant growth rate, it is generally only used for companies with
stable growth rates in dividends per share.

Formula: p= d1/r-g

where:P=Current stock priceg=Constant growth rate expected fordivi

dends, in perpetuityr=Constant cost of equity capital for thecompany (
or rate of return)D1=Value of next year’s dividends

What Does the Gordon Growth Model Tell You?

The Gordon Growth Model values a company's stock using an assumption of
constant growth in payments a company makes to its common
equity shareholders. The three key inputs in the model are dividends per
share, the growth rate in dividends per share, and the required rate of return.

Modiagliani Miller theory of capital structure:

Definition
The Modigliani-Miller theory of capital structure proposes that the market value of a firm is
irrelevant to its capital structure, i.e., the market value of a levered firm equals the market value
of an unlevered firm if they are within the same class of business risk. This approach believes
there is no optimal capital structure, and that the valuation of the firm depends on its operating
income.
Formula
The Modigliani-Miller theory believes that valuation of a firm is irrelevant to its capital structure.
The equation describing this relationship is as follows:
VU = VL
where VU is the market value of an unlevered firm (capital is represented by equity only), and VL is
the market value of a levered firm (capital is represented by a mix of debt and equity).
Thus, the market value of a firm depends on the operating income and business risk rather than
its capital structure. Therefore, the market value of an unlevered firm can be calculated using the
following formula:
EBIT
VU = VL =
ke0
where EBIT is earnings before interest and taxes, and ke0 is the required rate of return on equity
of an unlevered firm.
The Modigliani-Miller theory of capital structure also believes that the weighted average cost of
capital (WACC) is fixed at any level of financial leverage and equals the required rate of return on
equity of an unlevered firm (ke0).
WACC = ke0