Investments Exam 2

expected return

the return that an investor expects a stock to earn over the next period

return volatility

we measure risk as the deviation of a security’s return from its expected return

risk aversion

risk averse investors require higher return for bearing higher risk

unsystematic risk

a risk factor that affects one asset or a few assets

systematic risk

risk factors common to the whole economy

covariance

measures the co-movement of two stock prices. Positive shows that the two prices tend to move in the same direction. Negative shows the tendency of the stocks to move in opposite directions

correlation coefficient

measures the strength of the relationship between the relative movements of two assets. Falls between -1 and 1

investment opportunity set

the set of all possible portfolios that one may construct from a given set of assets by altering the weights; at any given level of risk, investors choose the portfolio with the highest expected return

optimal risky portfolio

best combination of risky assets to be mixed with safe assets when forming the complete portfolio. Has the highest possible Sharpe ratio or the slope of the CAL

efficient frontier

set of portfolios that maximizes expected return at each level of portfolio risk; these portfolios have the lowest level of risk with a given expected portfolio return

separation property

implies portfolio choice, separated into two tasks: (1) determination of optimal risky portfolio and (2) personal choice of best mix of risky portfolio and risk-free asset

market portfolio

portfolio of all risky investments, held in proportion to their values

index model

relates stock returns to returns on broad market index and firm-specific factors

beta

sensitivity of security’s returns to the return on the market index; natural measure of systematic risk

positive beta

indicates that the return of an asset follows the general market trend

negative beta

shows that the return of an asset generally follows a trend that is opposite to that of the market

capm

says that the expected return on any security is the sum of risk free rate and a risk premium for exposure to market risk

security market line

represents expected return-beta relationship of CAPM. Graphs individual set risk premiums as a function of asset risk

alpha

abnormal rate of return (difference between the fair/predicted and the actual expected return on a stock)

positive alpha

stocks above the SML and they are undervalued because their return is greater than the expected return by the model

negative alpha

stocks below the SML and they are overvalued because their return is less than the expected return by the model

multifactor models

models of security returns that respond to several systematic factors

size anomaly

smaller firms have historically outperformed larger firms

book-to-market anomaly

“value” stocks have historically outperformed “growth” stocks. Growth stocks have a low book to market ratio and value stocks have a high book to market ratio

random walk

notion that stock price changes are random and unpredictable

efficient market hypothesis

prices of securities fully reflect available information

weak form emh

stock prices already reflect all information contained in history of trading

semi strong form emh

stock prices already reflect all public information

strong form emh

stock prices already reflect all relevant information, including inside information

technical analysis

search for recurrent/predictable price patterns to make trading decisions

fundamental analysis

research on determinants of stock value, ie earnings, dividend prospects, future interest rate expectations and firm risk

passive investment strategy

buying well-diversified portfolio without attempting to find mispriced securities

index fund

mutual fund which holds shares in proportion to market index representation

momentum effect

tendency of poorly or well performing stocks to continue abnormal performance over short horizons

reversal effect

tendency of poorly or well performing stocks to experience reversals in following periods

p/e effect

portfolios of low p/e stocks exhibit higher average risk-adjusted returns than high p/e stocks

small-firm effect

stocks of small firms can earn abnormal returns, primarily in january

neglected-firm effect

stocks of little-known firms can generate abnormal returns

book to market effect

shares of high book to market firms can generate abnormal returns

behavioral finance

a view of financial markets emphasizing potential implications of psychological factors affecting investor behavior

forecasting errors

individuals have limited time and attention. Many rely on rules of thumb or intuition. This results in underreaction or overreaction to news

overconfidence

people overestimate precision of beliefs or forecasts and overestimate their own abilities (to beat the market)

conservatism bias

investors are too slow in updating beliefs in response to recent evidence

representativeness bias

people are prone to believe a small sample is representative of broad population

framing

decisions affected by how choices are posed, ie gains relative to low baseline level or losses relative to higher baseline

mental accounting

a specific form of framing in which people segregate certain decisions

disposition effect

the reluctance of investors to sell shares in investments that have fallen in price

regret avoidance

people blame themselves more for unconventional choices that turn out badly, avoid regret by making conventional decisions

arbitrage

exploiting misplacing of 2 or more securities to make a profit

fundamental risk

a limit to arbitrage; can you hold your position until prices get corrected

implementation costs

a limit to arbitrage; exploiting mispricing is difficult; short selling can be very costly

model risk

a limit to arbitrage; does your model provide precise estimates? inaccurate models generate inaccurate stocks values

law of one price

identical assets should have identical prices- assets that generate identical future cash flows should have an identical price