Price Weighted Index
sum of stock prices / number of stocks in index adjusted for splits
three possible explanations for a portfolio manager outperforming the market
skill, luck, cheating
If EMH is true, what is impossible (or very hard)?
skill. (people who believe in the EMH do not generally recommend paying people to manage your money)
market cap =
# of shares * price per share
how much money is raised by the IPO
#NAME?
what are the three risks to bondholders
default, inflation, and opportunity cost
if the discount rate decreases
then the bond value increases
what bond is likely to have a higher yield: 1-yr norwegian bond or 10-yr norwegian bond
10-yr norwegian bond
what bond is likely to have a higher yield: microsoft 10-yr or greece 10-yr
greece 10-yr
what is required to know in order to predict returns using CAPM
beta
coupon rate =
CF1/principal
value of the bond
#NAME?
risks to bondholders
default, inflation, opportunity cost
default
bondholder does not get paid back at all, or not in full
inflation
bondholder is repaid in full, but the value of the payments is lowered
opportunity cost
bondholder is repaid in full, but the bondholder could have made a higher return elsewhere
the likely hood of getting repaid is a function of
ability to repay, willingness to repay
what country is more likely to default
greece
the more likely an issuer is to default
the higher the yield
longer maturity bonds are
riskier than shorter maturity bonds
usually yields are higher on
long term bonds
purpose of bond ratings
designed to reflect the probability of a bond issue going into default
Bankruptcy chapter 11
reorganization
bankruptcy chapter 7
liquidation
price of a bond =
PV of future cash flows
if we know bond terms then
-if we know yield we can determine price
-if we know price we can determine yield
principals that apply with bonds
-write down payments and dates
-discount payments
at maturity, the value of any bond must equal
its par value
current yield (CY) =
annual coupon payment/current price
Capital Gains Yield (CGY)
change in price/beginning of price
Expected total return = YTM =
expected CY + Expected CGY
what do you need to know to predict return?
risk (finance theory)
lower price today (of a stock) -->
higher expected rate of return
how does the market set the price
so that risky stocks have higher expected returns than safe stocks
finance theory assumes that investors like and dislike
like return and dislike risk
what attributes are processed efficiently by the market to set the correct price
sales, profits, debt levels, CEO personality, etc
z-score for percentage decline =
percentage decline/volatility
volatility
the standard deviation of the returns for a stock. with volatility we can predict the chance of a 50% drop. TOTAL RISK TO AN ASSET.
how is volatility calculated
using the historical returns for the stock
idiosyncratic risks
risks only to the company
systemic risks
risks to the entire financial system
two parts of volatility
-idiosyncratic, diversifiable, non-systematic
-systematic, non-diversifiable, non-idiosyncratic, beta
total risk =
standard deviation of returns
Beta
the portion of total risk that cannot be diversified away
expected return of a stock =
risk free rate + stock beta (market return - risk free rate)
expected return of a portfolio =
risk free rate + portfolio beta (market return - risk free rate)
CAPM
Capital Asset Pricing Model -- theory of how stocks are priced
CAPM assumes investors are paid to take risk in the form of
beta. CAPM --> all you need is BETA
CAPM assumes investors are not paid to take risk in the form of
volatility, that can be diversified away
two most common measures of financial risk
volatility and beta
finance theory assumes that people need to get paid to
own risky assets. (risky assets have higher expected returns)
revealed preference
economic idea that behavior shows what people really like. behavior is more important than words.
-If you undertake a behavior, RP states that you value that behavior at $0 or more
-not undertaking behavior RP states you value it at $0 or less
higher beta -->
higher expected return
risk aversion
a loss of a sum of money hurts more than the equivalent gain helps
publicly owned corporation
company whose shares are held by the investing public, which may include other corporations as well as institutional investors
primary differences between hedge funds and mutual funds
hedge funds are less highly regulated, have more flexibility regarding what they can buy, and restrict their investors to wealthy, sophisticated individuals and institutions
money markets are markets for
short term debt securities such as treasury bills and commercial paper
4 most fundamental factors affecting the cost of money
production opportunities, time preferences for consumption, risk, and inflation
inflation increases, interest rates
increase and vice versa
the yield curve shows the relationship between
bonds' maturities and their yields
reinvestment rate risk
risk that interest rates will decline which will lead to a decline in the income provided by a bond portfolio as interest and maturity payments are reinvested