Exam #2 - Conceptual

1. What is risk?: The probability that actual future returns will deviate from expected returns

2. What does risk represent: The variability of returns

3. What does risk imply?: A chance for some unfavorable event to occur

4. What are examples of risk?: Uncertainty in net income caused by revenue, labor cost, inventory, or exchange rate

5. What is average return?: Average % return on investment over a sample time period

6. What is variance?: How far do returns fall from the mean or average

7. What is a return?: The interest or % that we earn over a time period (typically a year or month

8. If variance increases, what happens to risk (volatility): It increases

9. What formula do you use if calculating annual return?: E(R)

10. What does the E(R) formula represent?: The capital gain + the dividend yield

11. What does Rhp find?: The total compounded interest earned over a time period of investment

12. What does Rgeo find?: Annual compounded return

13. A Random Variable: Some measurement that can have a number of possible future outcomes

14. Examples of Random Variables: Temp, sales, expenses

15. What is a probability distribution: A function that assigns probabilities to the various possible outcomes that a random variable can have

16. What are the two forms of probability distributions?: Discrete ad Continuous

17. How many possible outcomes are there in a discrete distribution?: Finite

18. How many possible outcomes are there in a continuous distribution?: Infinite 19. What must probabilities add up to?: 1

20. What can we use a distribution to calculate?: Expected value and variance

21. What does variance measure?: The spread of the distribution or variation in possible outcomes about the expected value

22. 68%, 95%, 99.7%: 1 SD from mean, 2 SD from mean, 3 SD from mean

23. Name the two sources for return on a stock: Gain in price (capital gain) and any dividend paid

24. What can standard deviation also be called?: Stand Alone Risk which implies the risk associated with only investing in that stock

25. If two stocks have the same E(R), what can we use to compare them?: The SD.

26. 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

27. 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

28. COV Formula: COV= SD/Mean

29. What is a portfolio?: A collection of two or more assests

30. What is the goal of a portfolio?: To increase assets and decrease risk of portfolio

31. What does correlation measure?: How much two variables move or vary together

32. 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

33. In reality, all stocks are ___ correlated because...: Positively; because macro economic events move all stocks in the same direction

34. 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.

35. When decreasing correlation, what happens to the SD: It also deceases because it is more diversified

36. T/F: We can remove all risk: False

37. What does correlation capture?: It identifies that stand alone risk for a firm can be divided into market-wide risk and firm-specific risk

38. 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"

39. What is Market Risk is also known as?: Non-diversifiable risk, systematic risk, relevant, rewardable

40. 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

41. What is Firm Specific Risk also known as?: Non-systematic or diversifiable risk

42. What kind of risk should investors be rewarded for?: Non-diversifiable

43. At how many assets is a firm considered completely diversified?: 30

44. What is the minimum SD that we can reach through diversification?: The market risk because is can not be diversified away

45. What is the market risk premium?: The excess return required for the investors to buy the market portfolio (the bonus)

46. 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.

47. If ß=1: that means the systematic risk is the same as the avg investment

48. If ß>1: Stock "I" has greater systematic risk

49. What does beta predict?: The EXPECTED relationship between the market return and the return on the individual stock

50. What does CAPM stand for?: Capital Asset Pricing Model

51. E(R)-Rf: Difference between market index (like S&P 500) and Treasury Bill

52. What is the Security Market Line?: Graphically represents CAPM. Shows the required return given Beta

53. 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

54. 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

55. What is intrinsic value?: Net present value

56. What is the process of finding a stock called?: Fundamental Analysis

57. Primary Market Transaction: When an existing public firm issues new shares

58. Secondary Market Transaction: Market when existing public choices are traded

59. IPO: Initial Public Offering, when a private firm sells shares of public ownership

60. What happens when a firms net income increases?: dividends increase, stock prices increase

61. What happens when a firms sales increases?: Net income increases, dividends increase, stock prices increase

62. What happens when a firms risk increases?: Return increases, stock price decreases

63. What is the difference between expected return and a stocks required return?: Expected return is based on current price and expectations on future price

64. 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

65. Should one accept or reject a project if NPV <$0: Reject if NPV is less than $0

66. Return rate is also known as: Cost of equity, cost of capital, and CAPM

67. If cost of capital increases: leftover decrease

68. 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

69. When would you accept the IRR?: If IRR is greater than the required rate of return

70. Independent Project: Taking one project does not prevent me from taking another

71. Mutually Exclusive Project: If I pick ONE project, I can no longer pick another "pick the best"

72. Contingent Project: If I take one project, I have to take them all

73. Why do IRR and NPV lead you two different ways?: because NPV uses cost of capital while IRR is its own rate

74. Why do the IRR rule and NPV rule differ?:

1. timing of cashflows 2. scale of project 3. you can multiply IRR

75. What is the payback measuring?: Liquidity, so how long does it take for the firm to recover its inital investment

76. Payback formula: Initial cost/annual cash flow

77. T/F: the lower payback, the better: True

78. 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

79. What does the Profitability Index measure?: Is used when a firm is constrained by money, employees, machine hours, or lend. An efficiency measure

80. PI (budget Constraint) equation: NPV+Initial Cost/Initial Cost

81. PI (resource constrained) Equation: NPV/# of resources used

82. How did the American Dream lead to the 2008 financial crisis?: Everyone believed they should own a house and so lenders and stakeholder relaxed

83. 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

84. 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

85. T/F: Housing prices ALWAYS rise: False

86. 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)

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

88. How were MSB rated?: Fot default Risk. AAA

89. T/F: Housing problems are local: FALSE; they are national

90. In 2006, what happened when housing prices began to fall?: Mortgage holders began to default and MSB began to fall in value

91. T/F: Credit Default Swaps are betting on the price of an asset to fall: True

92. 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

93. NPV Pros and Cons: Pros: uses cost of capital and is a direct measure of shareholder wealth Cons: hard to explain

94. IRR Pro and Cons: Pro: Easy to explain Con: Does not use cost of capital and can conflict with NPV

95. What are the weaknesses of the finite holding periods?: Assuming a future selling price and predicting future dividends

96. What makes the infinite holding period reasonable?: The price of the stock = PV of all future dividends and because corporations have unlimited life

97. What are the weaknesses of the infinite holding periods?: Assuming a constant growth rate and very sensitive to g (not accurate)