FIN 341 Exam 3 (EDUARDO) (MISSISSIPPI COLLEGE)

The chance that some unfavorable event will occur.

Risk

What is the average investor's risk profile?

It varies over time. Prior to recent financial crisis, putting money into riskier investments. After, moved away from riskier investments and flocked toward safer investments such as treasury securities.

What do investors require in order to take on risk?

An investor's goal should be to earn returns that are more sufficient to compensate for the perceived risk of the investments.

To entice investors to take on more risk, you have to provide them with higher expected returns.

What happens to risk as you increase the number of stocks in your portfolio.

Decreases

What are the two types of risk?

Stand-Alone risk

Portfolio risk

The risk an investor would face if he or she held only one asset. The asset is considered by itself.

Stand-Alone risk

Not the weighted average of the individual stocks' standard deviations. The risk is generally smaller than the average of the stocks' because of diversification.

Portfolio risk

[Stocks in particular, are held in portfolios; but it is necessary to understand stand-alone risk to understand risk in a portfolio context.]

Part of a security's risk associated with random events

Can be eliminated by proper diversification.

Also known as company specific or unsystematic risk; risk that is eliminated by adding stocks

Diversifiable risk

Risk that remains in a portfolio after diversification has eliminated all company specific risk.

Also known as non-diversifiable risk/systematic or beta risk.

Risk that remains even if the portfolio holds every stock in the market.

Market risk

Risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk.

Measured by the extent to which the stock moves up or down with the market

Relevant risk

Measure of how far the actual return is likely to deviate from expected return

Standard deviation

Why is there a decline in portfolio risk first and then it stops decreasing?

Risk declines as stocks are added but at a decreasing rate. Once 40 or 50 stocks are in the portfolio additional stocks do little to reduce risk.

Once you get risk down all the way down to the market risk, it is not decreaseable. You cannot decrease market risk.

Which risk is irrelevant?

Diversifiable risk

Which risk is relevant?

Market risk

How do measure the relevant portfolio risk?

Extent to which the stock moves up or down with the market.

A metric that shows the extent to which a given stock's returns move up and down with the stock market; measures market risk or tendency of a stock to move with the market

Beta

What does a beta of 2 or .5 mean?

Beta of 2 is twice as risky as an average stock

Beta of .5 is only half as risky.

1 is average risk.

Most widely used method for estimating required rates of return on stocks.

CAPM

Formula of CAPM

ri = rf+ [rm-rf]b

The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk

Shows the premium that investors require for bearing the risk of an average stock, RPm

Market risk premium

Equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.

Required return on a stock = risk free return + (market risk prem) (stock's beta)

SML (Security Market Line)

In the context of one single security, how do you measure return?

CAPM

How do you measure risk? What would a tighter or wider distribution of returns mean in terms of risk?

Sigma is determining factor.

Tighter would be less risk

Wider is more risk.

Have a good feel for expected return and the risk premium that it requires given risk (lottery problem)

Understand the concept of correlation (correlation coefficient) and its impact on diversification

[Diversification is completely useless for reducing risk if the stocks in the portfolio are perfectly positively correlated. Combining stocks into portfolios reduces risk but does not completely eliminate it]

What is the range of the correlation coefficient. What would a -1 coefficient mean?

A measure of the degree of relationship between two variables; -1 would mean perfectly negatively correlated.

The rate of return expected to be realized from an investment (r-hat); sum of prob of demand x rate of return

Expected return

The min rate of return that a stockholder considers acceptable.

Required return (ri)

The rate of return on a common stock that a stockholders in some past period. May be greater or less than expected return and/or required return

Actual (Realized) Return (r bar)

The true price of the stock

Intrinsic price (P^o)

Expected rate of growth in dividends per share.

Growth rate

The minimum rate of return on a common stock that a stockholder considers acceptable.

Required rate of return (rs)

How do you value a stock?

Determined by the cash flows its is expected to provide.

What cash flows are included in a stock?

Dividends the investor receives each year while he or she holds the stock and price received when the stock is sold. Final price includes the original price plus an expected capital gain.

What is the model if you are going to keep the stock forever vs sell it?

Dividen model.

If you sell it, present value of current/expected dividends. S

Same model regardless? No.

What basic patterns would dividends follow?

Can be rising, falling, or fluctuating randomly.

Has no growth; a common stock whose future dividends are not expected to grow at all

Zero growth stock

When can the constant growth model be used?

When dividends are growing at a constant rate.

Gordon model

Gordon Model formula

rs = d1 / p0 + g

Can we have g > rs

No. Required rate of return must be more than the long run growth.

How do you compute the expected rate of return of a constant growth stock?

Gordon Model

What is the difference between normal growth and super growth?

Supergrowth is the part of a firm's life cycle in which it grows much faster than the economy as a whole.

How does equilibrium in the stock market happen?

The condition under which the expected return on a security is just equal to its required return and price is stable.

What is the condition that must be met? Otherwise, what takes place?

A stock's expected rate of return must = its required rate of return and actual market price of the stock must = its intrinsic value.

E > I = sell (overvalued) E

How would equilibrium change?

Stock prices are not constant

They change violently and rapidly. Supply and demand also change.

Hybrid, similar to a bond and common stock.

Has a par value and a fixed dividend that must be paid before dividends can be paid on the common stock.

Entitles its owners to regular, fixed dividend payments

Preferred stock

How do you value preferred stock?

Vp = Dp/rp