POI Exam 2

CAPM (Capital Allocation Pricing Model)

Models risk vs return

SML (Security Market Line)

Graphic representation of CAPM portfolios

• Beta vs Expected Return

• Slope is market risk premium

Use as benchmark for fair return on a risky asset and hurdle rate for internal projects

CAPM Assumptions Investor Behavior

• Investors are rational and use mean-variance analysis

• Investors have a common planning period and the same horizon

• Investors have identical input lists (all available public info)

CAPM Assumptions Market Structure

• All assets are publicly traded on a stock exchange

• Investors borrow and lend at the same risk-free rate

• No taxes/costs of investment

CAPM Equilibrium

Assumes that all investors will pick the market portfolio as the optimal risky portfolio

• Each security is held in proportion to its market value

Mutual Fund Theorem

All investors desire some portfolio or risky assets and that can be satisfied by a single mutual find composed of that portfolio (market)

Alpha

Abnormal rate of return on security in excess of the predicted return by CAPM

• Positive alpha means underpriced, long position

• Negative alpha means overpriced, short position

Index Model

Realized returns (historical) and mean Beta equation

CAPM Limitations

1. Uses expected returns, not historical returns

2. Theoretical market portfolio of all risky assets

3. Beta changes overtime

APT (Arbitrage Pricing Theory)

Strategy to create riskless profit by identifying mispriced securities in different markets

• Roll states that an efficient market should prevent this

Random Walks

Notion that all stock prices change randomly and are unpredictable

EMH (Efficient Market Hypothesis)

Prices of securities reflect all publicly available information

• Weak: Past data

• Semi: Past and current data

• Strong: Past, current, and insider information

• Competition as a source of efficiency (exploit profit abilities)

Technical Analysis

Look for patterns or trends in data (Chartism)

• Resistance: Max price

• Support: Min price

• If a market is at least weak, this is useless

Fundamental Analysis

Research on price determinants

• Industry analysis, compare financial numbers, rations (PE)

• Macroeconomic factors (inflation)

• Risk evaluation (CFs, discount rates)

• Intrinsic Value (value is the PV of future CFs)

Market Anomolies

Inefficiencies in the market

• Insider info

Passive Strategy

Well diversified portfolio without identifying mispriced securities

• Index Fund: Mutual fund holds shares in proportion to the market index

• Consistent with semi-strong

Magnitude Issue

Efficiency is relative not binary

Selection Bias Issue

Investors who find success don’t share

Lucky Events

Lucky events receive disproportionate attention

Momentum Test (Weak)

Stocks have momentum and investors will contribute

• Makes technical analysis worthwhile sometimes

Reversal Effect (Weak)

Stocks that have momentum and resulting price changes will return to normal in the long run

P/E Effect (Semi)

Portfolios with low PE ratios have higher risk-adjusted returns that high PE stocks

Small-Firm Effect (Semi)

Small firms may have abnormal returns (primarily in January)

Neglected Firm Effect (Semi)

Stocks of little known firms can generate abnormal returns

Book-to-Market Effect (Semi)

Shares of high book-market stocks can generate abnormal returns

Post-Earnings Announcement Price Drift Anomaly (Semi)

Sluggish response of price to earnings announcement

• Abnormal return on announcement day, momentum continues

Bubbles and Efficiencies (Semi)

Bubbles raise prices, but even if prices are inaccurate, had to take advantage

Are markets efficient?

Enough that only superior information will earn profit

Behavioral Finance

Study of financial market models with emphasis on psychological factors

Forecasting Errors (IP)

People overvalue recent experiences than prior belief (recency bias)

Overconfidence (IP)

People overestimate their own abilities and precision

Conservatism (IP)

Investors are too slow to update their beliefs in response to recent evidence

Sample Size (IP)

Belief that a small sample group represents the entire population

Framing (Behavioral)

Decisions change based on how information is presented

Mental Accounting

People segregate certain decisions (investment accounts)

Regret Avoidance

Tendency to blame self for unconventional choice

Prospect Theory

Investor utility depends on gain/loss rather than wealth

Limits of Arbitrage

1. Fundamental Risks: Can you hold until prices corrected?

2. Implementation costs

3. Model risk

Zero Coupon Bond

Pays no coupons, sells at discount, provides payment of par only at maturity

Indenture

Contract

• Covenants: Requirements of a bond

US Treasury Quotes

T-notes/bonds as over the counter quotes

Mortgage Bonds

Collateral is real-estate properties

Debenture

Unsecured bond (not backed by collateral)

Corporate Bonds

Floating rate, callable, puttable, convertible

Floating-Rate Bond

Coupon rates periodically reset according to specific market date

Callable Bond

Allow issuer to repurchase at a specific call price

• Higher coupon rates

Puttable Bond

Allow bondholder to exchange for par value or extend to a given number of years at a specific put price

Convertible Bond

Allow bondholder to exchange for specific number of shares

• Lower coupon rates

Hybrid Security - P/S

Commonly pays fixed dividend (perpetuity)

• Taxed less for between corporations

Index Bonds

Payments are tied to an index or price of a commodity

• Ex: TIPS to CPI

Coverage Ratios

Company earnings to fixed costs

Leverage Ratios

Debt to equity

Liquidity Ratio

Current: CA to CL

Quick: Assets - Inv = Liabilities

Profitability Ratio

Measures of ROR on assets or equity

Default Premium

Increment to promised yield that compensates investor for default risk

Yield Spread

Change in yield between bond grades

Credit Default Swaps (CDS)

Insurance policy for lender against defaults

Yield to Maturity

R that makes the PV of bonds payment equal to the market price

Realized Compounded Return

ROR including all coupons reinvested until maturity

• Same as YTM if reinvestment IR is the same rate

YTM v HPR

• YTM measures average rate of return

• HPR is the ROR over a single period

Term Structure of IRs

Relation between YTM and TTM of bonds

• Yield Curve: YTM as function of TTM

• Expectations Hypothesis: YTM only determined by expectations of future short-term IRs

Liquidity Preference Theory

Investors demand premiums on longer bonds

• Liquidity risk

Bond Risks

• Default

• Inflation

• Liquidity

• Market Interest Rate

  • Price risk: as IRs increase, the price decreases

  • Reinvestment Rate Risk: Not able to reinvest at the same rate