Finance Quiz #3

How would we maximize diversification or the reduction of risk?

Have negatively correlated stocks.

Market risk (systematic risk) is _____.

Non-Diversifiable.

What is significant to know about market risk?

It cannot be diversified away.

Examples of market risks:

• War
• Anything that affects all stocks

Company-unique risk (unsystematic risk) is _____.

Diversifiable.

Examples of company-unique risks:

Manufacturer's one location is destroyed, or fraud.

Beta

A measure of market risk.

What does CAPM measure?

The risk-return trade-off when risk is measured according to the beta.

CAPM Equation

Required Return = Risk-free rate of interest + Beta * (Return on the market index - Risk-free rate of interest)

CAPM Equation in words:

Equates the required rate of return on a stock to the risk-free rate + a risk premium for the stock's premium for the stock's systematic (market) risk.

S&P 500 Index

An index of 500 stocks chosen from NYSE & NASDAQ for market size and liquidity

Dow Jones Industrial Average Index (Dow 30/Dow)

Calculated by adding together the share prices of the 30 constituent companies.

NASDAQ 100 Index

An index composed of the 100 largest, most actively traded U.S companies listed on the NASDAQ stock exchange.

Common stockholders _____.

Own the firm.

Does common stock have the highest risk?

Yes

Common stock cash flows are _____ certain than bonds.

Less.

Can preferred stock have multiple and different classes?

Yes

If the required rate of return went down, the price/value would ____.

Increase.

If the required rate of return went up, the price/value would ____

Decrease.

Price-Earnings (PE) Ratio

Price per Share / Earnings per Share

Growth Rate (G) =

Return on equity (ROE) * Retention rate