Exam #2 - Conceptual

What is risk?

The probability that actual future returns will deviate from expected returns.

What does risk represent?

The variability of returns.

What does risk imply?

A chance for some unfavorable event to occur.

What are examples of risk?

Uncertainty in net income caused by revenue, labor cost, inventory, or exchange rate.

What is average return?

Average % return on investment over a sample time period.

What is variance?

How far do returns fall from the mean or average.

What is a return?

The interest or % that we earn over a time period (typically a year or month).

If variance increases, what happens to risk (volatility)?

It increases.

What formula do you use if calculating annual return?

E(R).

What does the E(R) formula represent?

The capital gain + the dividend yield.

What does Rhp find?

The total compounded interest earned over a time period of investment.

What does Rgeo find?

Annual compounded return.

What is a Random Variable?

Some measurement that can have a number of possible future outcomes.

Examples of Random Variables?

Temp, sales, expenses.

What is a probability distribution?

A function that assigns probabilities to the various possible outcomes that a random variable can have.

What are the two forms of probability distributions?

Discrete and Continuous.

How many possible outcomes are there in a discrete distribution?

Finite.

How many possible outcomes are there in a continuous distribution?

Infinite.

What must probabilities add up to?

1.

What can we use a distribution to calculate?

Expected value and variance.

What does variance measure?

The spread of the distribution or variation in possible outcomes about the expected value.

What does 68%, 95%, 99.7% represent?

1 SD from mean, 2 SD from mean, 3 SD from mean.

Name the two sources for return on a stock.

Gain in price (capital gain) and any dividend paid.

What can standard deviation also be called?

Stand Alone Risk which implies the risk associated with only investing in that stock.

If two stocks have the same E(R), what can we use to compare them?

The SD.

Assuming E(R)s are equal, what does the SD tell one about risk?

The greater the SD, the more risky; so we would choose the stock with a smaller SD.

If two stocks have different E(R), how do we measure risk?

Using the coefficient of variation formula. We will take the stock with the smallest COV.

COV Formula?

COV= SD/Mean.

What is a portfolio?

A collection of two or more assets.

What is the goal of a portfolio?

To increase assets and decrease risk of portfolio.

What does correlation measure?

How much two variables move or vary together.

What can one infer about positively correlated stocks?

The stocks tend to move together.

In reality, all stocks are ___ correlated because…

Positively; because macro economic events move all stocks in the same direction.

What can one infer about negatively correlated stocks?

Stock returns tend to move in opposite directions.

When decreasing correlation, what happens to the SD?

It also decreases because it is more diversified.

T/F: We can remove all risk?

False.

What does correlation capture?

It identifies that stand alone risk for a firm can be divided into market-wide risk and firm-specific risk.

What is Market Wide Risk?

Market events like: recessions, booms, changes in interest rates, taxes, politics, oil prices, wars; cause all stocks to move up or down together.

What is Market Risk also known as?

Non-diversifiable risk, systematic risk, relevant, rewardable.

What is firm specific risk?

Economic and business events that impact only one or a few firms at a time.

What is Firm Specific Risk also known as?

Non-systematic or diversifiable risk.

What kind of risk should investors be rewarded for?

Non-diversifiable.

At how many assets is a firm considered completely diversified?

30.

What is the minimum SD that we can reach through diversification?

The market risk because it cannot be diversified away.

What is the market risk premium?

The excess return required for investors to buy the market portfolio.

What is Beta?

A risk index that allows us to compare the systematic risk of an individual asset vs. the systematic risk of the market portfolio.

If ß=1?

That means the systematic risk is the same as the average investment.

If ß>1?

Stock 'I' has greater systematic risk.

What does beta predict?

The EXPECTED relationship between the market return and the return on the individual stock.

What does CAPM stand for?

Capital Asset Pricing Model.

E(R)-Rf?

Difference between market index (like S&P 500) and Treasury Bill.

What is the Security Market Line?

Graphically represents CAPM. Shows the required return given Beta.

What do we know if expected return < required return?

Stock is overvalued, so investors will sell stock.

What do we know if expected return > required return?

Stock is undervalued, so investors will buy the stock.

What is intrinsic value?

Net present value.

What is the process of finding a stock called?

Fundamental Analysis.

Primary Market Transaction?

When an existing public firm issues new shares.

Secondary Market Transaction?

Market when existing public choices are traded.

What is IPO?

Initial Public Offering, when a private firm sells shares of public ownership.

What happens when a firms net income increases?

Dividends increase, stock prices increase.

What happens when a firms sales increase?

Net income increases, dividends increase, stock prices increase.

What happens when a firms risk increases?

Return increases, stock price decreases.

What is the difference between expected return and a stock's required return?

Expected return is based on current price and expectations on future price.

What is the purpose of capital budgeting?

To plot a course of action for the firm.

Should one accept or reject a project if NPV <$0?

Reject if NPV is less than $0.

Return rate is also known as?

Cost of equity, cost of capital, and CAPM.

If cost of capital increases?

Leftover decrease.

What is IRR?

Internal rate of return; discount rate that makes the net present value of all cash uses/sources equal to 0.

When would you accept the IRR?

If IRR is greater than the required rate of return.

Independent Project?

Taking one project does not prevent me from taking another.

Mutually Exclusive Project?

If I pick ONE project, I can no longer pick another.

Contingent Project?

If I take one project, I have to take them all.

Why do IRR and NPV lead you two different ways?

Because NPV uses cost of capital while IRR is its own rate.

Why do the IRR rule and NPV rule differ?

1. Timing of cashflows 2. Scale of project 3. You can multiply IRR.

What is the payback measuring?

Liquidity, so how long does it take for the firm to recover its initial investment.

Payback formula?

Initial cost/annual cash flow.

T/F: the lower payback, the better?

True.

What are the weaknesses of the Payback Method?

1. Ignores TVM 2. No set decision rule on good payback 3. Ignores time beyond payback period.

What does the Profitability Index measure?

An efficiency measure used when a firm is constrained by resources.

PI (budget Constraint) equation?

NPV + Initial Cost / Initial Cost.

PI (resource constrained) Equation?

NPV / # of resources used.

How did the American Dream lead to the 2008 financial crisis?

Everyone believed they should own a house, leading to relaxed lending practices.

How did the Mortgage Issue lead to the 2008 financial crisis?

Increased number of mortgages issued, reckless spending, sub-prime lending.

Why was sub-prime lending problematic during the 2008 financial crisis?

Adjustable Rate Mortgages became unaffordable after initial low rates.

T/F: Housing prices ALWAYS rise?

False.

How did the Unregulated Bank Behavior lead to the 2008 financial crisis?

Banks bought mortgages to repackage them as investments.

T/F: In MBS investors get paid when mortgage holders don't make their monthly payments?

False.

How were MBS rated?

For default risk. Typically AAA.

T/F: Housing problems are local?

False; they are national.

In 2006, what happened when housing prices began to fall?

Mortgage holders began to default and MBS began to fall in value.

T/F: Credit Default Swaps are betting on the price of an asset to fall?

True.

T/F: Housing prices continued to fall which made these swaps too expensive for banks to pay off, so banks had to bail out borrowers?

False; the government had to bail out banks.

NPV Pros and Cons?

Pros: Uses cost of capital and is a direct measure of shareholder wealth; Cons: Hard to explain.

IRR Pros and Cons?

Pro: Easy to explain; Con: Does not use cost of capital and can conflict with NPV.

What are the weaknesses of finite holding periods?

Assuming a future selling price and predicting future dividends.

What makes the infinite holding period reasonable?

The price of the stock equals PV of all future dividends.

What are the weaknesses of infinite holding periods?

Assuming a constant growth rate and very sensitive to g.