FINA 3000 Pope UGA Test 2

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

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 ad 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

68%, 95%, 99.7%

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 assests

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. This means if stock A is above its average, stock B tends to also be above its average

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. This means if stock A is above average, stock B is probably below average.

When decreasing correlation, what happens to the SD

It also deceases 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 "High tide raises all-risk"

What is Market Risk is also known as?

Non-diversifiable risk, systematic risk, relevant, rewardable

What is firm specific risk?

economic and business events like: volatility due to an event unique to firm or industry; 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 is can not be diversified away

What is the market risk premium?

The excess return required for the investors to buy the market portfolio (the bonus)

What is Beta?

A risk index that allows us to compare the systematic risk of an individual assest vs. the systematic risk of the market portfolio. This lets us know how risky our investment is in comparison to the avg investment.

If ß=1

that means the systematic risk is the same as the avg 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 which drops the price until Beta=required return

What do we know if expected return > required return?

Stock is undervalued, so investors will buy the stock and price will increase until Beta=required return

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

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 increases?

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 stocks 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 only take on projects that expand shareholder value

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; what discount rate is required to make the net present value of all cash uses/sources equal to 0. The maximum value that cost of capital can be

When would you accept the IRR?

If IRRr≥ r

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 "pick the best"

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 inital 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?

Is used when a firm is constrained by money, employees, machine hours, or lend. An efficiency measure

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 and so lenders and stakeholder relaxed

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

- there was a race to meet demand for houses

- increase in the number of mortgages issues

- reckless spending

- sub-prime lending

Why was sub-prime lending (loans to those with bad credit scores) problematic during the 2008 financial crisis?

- The Adjustable Rate Mortgage was lower for the first 3 years and then became MUCH higher

- The sub-prime borrowers could not afford higher payments, so they would sell or refinance

T/F: Housing prices ALWAYS rise

False

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

- Banks were buying mortgages to repackage them as investments (called mortgage backed securities)

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

False

How were MSB rated?

Fot default Risk. 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 MSB 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 barrowers

FALSE; the gov't 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 Pro and Cons

Pro: Easy to explain

Con: Does not use cost of capital and can conflict with NPV

What are the weaknesses of the finite holding periods?

Assuming a future selling price and predicting future dividends

What makes the infinite holding period reasonable?

The price of the stock = PV of all future dividends and because corporations have unlimited life

What are the weaknesses of the infinite holding periods?

Assuming a constant growth rate and very sensitive to g (not accurate)