to entice investors to take on more risk you have to provide
higher expected returns
the slope of the risk-return line indicates how much additional return ?
an individ investor requires in order to take on a higher level of risk
a steep slope would mean?
an investor is more averse to taking a risk
at any point in time, an investor's goal should be to earn returns that are
more than sufficient to compensate for the perceived risk of the investment---getting above the risk-return trade-off line
the returns that companies have to pay their investors represent the companies costs of /
obtaining capital
a hazard; a peril, exposure to loss or injury
risk
asset's risk can be analyzed in two ways?
1. stand alone risk where asset is considered by itself or portfolio basis where asset is held as one of a number of assets in a portfolio
risk an investor would face if he/she held only this one asset
stand alone risk
r-hat ^ =?
expected rates of return
r bar - =
realized (historical) rates of return
Q =
sigma = sd
CV =
coefficient of variation
listing of possible outcomes or events with a probability assigned to each outcome
probability distribution
the weighted average of the probability distribution of possible results
expected rate of return
to get expected rate of return you would do what?
multiply the probability X rate of return if demand occurred and then add all of the % together
when probability distribution is tighter, the risk is?
lower
when sd is smaller what is the risk?
lower
in order to calculate the variance you would follow what steps?
get deviation= actual - expected return. square the deviation. then multiply the squared deviation by the probability
measure of the variability of a set of observations
sd
key question with using historical data to forecast future is?
how far back should we go
coefficient of variation has the formula?
sd/expected rate of return
standardized measure of the risk per unit of return
coefficient of variation
these investors dislike risk and require higher rates of return as an inducement to buy riskier securities
risk aversion
expected rate of return on single investments
expected ending value-cost/cost
the difference b/w the expected rate of return on a given risky asset and that on a less risky asset
risk premium
if riskier securities do not have higher expected returns than less risky investments as estimated by the marginal investor,
buying and selling will occur until this takes place
a model based on the proposition that any stock's required rate of return is equal to the risk free rate of return plus a risk premium that reflects only the risk remaining after diversification
CAPM Capital asset pricing model
the weighted average of the expected returns on the assets held in the portfolio
expected return on portfolio
to calculate the expected return on portfolios you would do what?
multiply the expected return for each stock by it's % of total dollars invested. then, you would add all the totals up to get expected return
the return that was actually earned during some past period
realized rate of return
the portfolios risk is generally ? than the average of the stocks' q b/c ?
lower. b/c diversification lowers the portfolios risk
the tendency of two variables to move together
correlation
a measure of the degree of relationship b/w two variables
correlation coefficient
how can a portfolio consisting of two risky investments have no risk when they are combined into the portfolio
b/c they move countercyclically
in regards to the correlation coefficient, p = what when the stocks are perfectly negative, positive correlation, and independent
-1,1,0
studies have indicated that on average, the correlation b/w the returns of 2 randomly selected stocks is about? this shows combining stocks into a portfolio does what?
.3, reduces the risk but does not eliminate it
as a rule on average, portfolio risk declines as the number of stocks?
increases
that part of a security's risk associated with random events; it can be eliminated by proper diversification. this risk is also known as company specific or unsystematic risk
diversifiable risk
the risk that remains in a portfolio after diversification has eliminated all company-specific risk. this risk is also known as nondiversifiable or systematic or beta risk
market risk/systematic risk
portfolio's risk declines but at a decreasing rate. once at ? stocks, additional stocks do little to reduce risk
40-50
portfolio's total risk can be divided into 2 parts?
diversifiable risk and market risk
diversifiable risk is the risk that is ?
eliminated by adding more stocks
market risk is the risk that ?
remains even if the portfolio holds every stock in the market
diversifiable risk is caused by ?
random unsystematic events such as lawsuits, strikes, unsuccessful or successful marketing, winning/losing of major contract and other events particular to the individual firm
market risk is caused by?
macro factors such as war, inflation, recessions, high interest rates, and cannot be eliminated by diversification
a portfolio consisting of all stocks
market portfolio
risk that remains once the stock is in a diversified portfolio is its contribution to the portfolio's market risk.
relevant risk
a metric that shows the extent to which a given stocks returns move up and down with the stock market
beta coefficient
beta measures
market risk
why would a person not hold a market porfolio
1. high admin costs and commissions 2. index funds can be used by investors for diversification 3. some ppl think they can pick stocks that will "beat the market" 4. some ppl thru superior analysis can beat the market
the risk that remains once a stock is in a diversified portfolio is its /
contribution to the portfolio's market risk
by definition, ba=? b/c an average risk stock is one that tends to move up and down in step with the general market
1
on graphs of stocks in a porfolio, what do the slopes represent?
beta coefficients
a large porfolio with b=1 would have its diversifiable risk ? but would still move up and down with the broad market averages and thus?
removed, have a degree of risk
because diversified risk can be eliminated by diversification in portfolio's, the only risk that is required to have compensation is ?
marketable risk
what is the most relevant measure of a stocks risk
beta
how do you find beta of a portfolio?
% of money invested in that stock * beta of that stock and add all these together
if ri hat is less than ri the typical investor will do what with this stock
not buy it or will sell it if it's already bought
r_rf = what?
risk free rate of return
r_rf is generally measured by?
return on US treasury securities
r_m =?
required rate of return on a portfolio consisting of all stocks, the market portfolio
the additional return over the risk-free rate required to compensate an average investor investor for assuming an average amount of risk
RP_m=(r_m-r_rf)
risk premium on the market and the premium on an average stock
RP_m
risk premium is actually hard to measure b/c
it is impossible to obtain precise est of the expected future return of the market
risk premium for a single stock?
RP_m * b of that stock
an equation that shows the relationship b/w risk as measured by beta and the required rates of return on individual securities
security market equation line
SML equation =?
required return on stock = risk free return + market risk premium * stock i's beta
an average stock with b=1 would have required return of? same as market
11%
for the graph of the SML, what is plotted on the vertical axis? horizontal axis?
va-required rates of return ha-risk by beta
the slope of the SML reflects the degree of?
risk aversion in the economy
the greater the average investor's risk aversion, what is the slope of the SML? how does this affect the risk premium and required rate of return
steeper slope. greater risk premium for all stocks and the greater the required rate of return on all stocks
the risk free rate (nominal or quoted rate) consists of 2 elements
1. real inflation-free rate of return r* and 2.inflation premium IP=to the anticipated rate of inflation
R_rf=?
r*+IP
the increase in r_RF leads to what in rates of return
0
how can a firm influence its market risk
by changes in the composition of its assets and thru changes in the amt of debt it uses
if there is no risk aversion, what would the slope of the SML line be?
0
what is one problem with the CAPM
there have been studies that show that their is no relationship b/w stocks return and their market beta and he CAPM is based primarily on the beta with no other variables
when deciding the riskiness of a stock why don't we look at the company of that stock?
b/c for mgt their primary goal is to maximize stock price, so the overriding consideration is the riskiness of the firms stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stock's risk as seen by investors
short term investments vs. long term in regards to risk?
long term investments are better bc eventually you even out the ups and downs
cheapest source of funds available often from?
credit unions
retirement funds funded by corporations or govt agencies for their workers and administered primarily by the trust dept of commercial banks or life insurance companies
pension funds
cooperative associations whose members are supposed to share a common bond, such as employees of same firm
credit union
take savings in the form of annual premiums;invest these funds in stocks, bonds, real estate, and mortgages
life insurance companies
corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, and short-term debt instruments issued by businesses and govt units
mutual funds
this service buys a portfolio of stocks of a certain type and then sell their own shares to the public
ETF exchange-traded funds
how do hedge funds differentiate from mutual funds?
they are unregulated
these organizations operate much like hedge funds but other than buy some of the stock of a firm, private equity players buy and then manage entire firms
private equity companies
most active secondary market and most impt to financial managers is
stock market
2 leaders of stock markets
NYSE and Nasdaq
2 basic types of stock
physical location exchange and electronic dealer-based markets
in the physical location exchange, members with ? offer shares for sale and members with ? bid for them. this makes it an?
sell orders, buy orders, auction markets
how does the OTC market differ from the physical location exchange
consists of stocks traded infrequently. dealers will buy when investor wants to sell and sell part of their stock when buyers want to buy
dealer market system consists of what 3 things
1. relatively few dealers holding inventories 2. thousands of agents/brokers to bring dealers with investors 3. comps, terminals, and electronic networks that provide a communication link between dealers and brokers
the difference between bid and ask prices
bid ask spread. reps the dealers profit
brokers and dealers who participate in the OTC market are members of ?
national association of securities dealers which licenses brokers and oversees trading practices
computer system used by NASD
NASDAQ automated quotation system
stock of privately owned corps
closely held stock
we can classify stock market exchanges into 3 distinct groups
outstanding shares of est. publicly owned companies that are traded: the secondary market 2. additional shares sold by established publicly owned companies 3. initial public offerings made by privately held firms
another name for outstanding shares
used shares
when the demand for shares at the offering price exceeds the number of shares issued
oversubscribed
in ? the actual transaction price is set at the highest price that causes all of the offered shares to be sold
dutch auction--Google used
the problem with using a newspaper to look at stock prices?
newspaper is yesterdays price
current price of a stock
market price
price at which the stock would sell if all investors had all knowable info about a stock
intrinsic value
price that balances buy and sell orders at any given time
equilibrium price
a market in which prices are close to intrinsic values and stocks seem to be in equilibrium
efficient market
most impt accounting ratio
return on common equity
market value ratios are used in 3 primary ways
1. by investors when they are deciding to buy or sell a stock 2. by investment bankers when they are setting the share price for a new stock 3. by firms when they are deciding how much to offer for another firm in a potential merger
market/book ratios typically exceed 1 which means
investors are willing to pay more for stocks than the accounting book values of the stocks
what are the problems with relying too heavily on ROE
1. it does not consider risk 2. it does not consider the amount of invested capital 3. too much focus on this can cause managers to turn down profitable projects
in the economy we have what 2 type pf ppl for financial markets
savers and borrowers
firms need capital so they can?
take on future profitable investments
for capital formation to occur businesses and ppl have to be able to?
exchange money and securities
Direct transfer: Business and savers can connect
directly via financial markets
Indirect transfer: Business and savers can connect
through a financial intermediary
thru a direct transfer Firms can borrow
by issuing bonds or they can sell some of their equity by issuing stock (equity shares)
with an indirect transfer thru an investment bank,
the bank underwrites the investment. may lose out on risk
with an indirect transfer thru financial intermediary
intermediary obtains funds from saver in exchange for it's securities. int holds business securities while saver holds banks
primary goal of financial manager
to maximize the value of the firm
how do bonds differ from stocks
bonds are debt-loans to the company, no ownership, are paid off first before stock
stocks are ownership, entities, paid off last if a company fails
what are capital gains and losses
when you buy a capital asset and later sell it for more=gain, less=loss
dividend yield=?
expected dividend divided by current price of share of stock
when using historical data to predict returns what is a key question and problem
how far back should we collect data. some info may be misleading if level of risk and return is likely to be different
who created CAPM
harry markowitz
modern portfolio theory says?
there should be diversification in investments to maximize expected return and minimize risk
the highest level of diversification is?
the market portfolio
expected inflation causes what kind of shift in the SML
upward parallel shift
increases in average investor risk aversion increase the market risk premium - investors on average will require a higher rate of return for the market portfolio - this would make the SML slope?
the SML steeper
if beta, the systematic risk of the firm, increases, the slope of sml will?
The slope of the SML can also become steeper
what is the difference b/w spot and future markets
future markets participants agree to buy or sell markets in the future. spot markets assets are bought or sold on the spot
what is the difference b/w money markets and capital markets
money markets are short term highly liquid debt securities. cap markets are intermediate and lont-term debt securities
primary vs. secondary markets
primary markets the company issues new stock and sells directly to investors. secondary market is what we know where stock is available and there are buyers and sellers
derivative is any security whose?
value is derived from the price of some other underlying asset
what are some recent trends in the financial market
globalization, technology, computers and telecommunications
what is a CDS
credit default swap. seller of the CDS will compensate the buyer if the loan defaults. seller makes a series of payments and in return receives payoff if loan defaults
naked CDS is ?
buying the CDS w/o an investment in the underlying asset
when Securitizing loans an agent does what?
? and creates new securities whose payoff?
buys up a pool of loans and creates new securities whose payoff is based on the underlying pool
this is where an entity issues several classes of securities backed by portfolio of loans
CDO Collateralized debt obligations
ipo?
private company goes public (initial public offering)
used to take a company private? reverse ipo
leveraged buyout
secondary stock markets include?
NYSE, AMEX
what is one way to measure the stock market--30 large companies
dow jones industrial average
how does s&p treat larger companies
there value is weighted
new equilibrium prices result from
trading
frictions with the market efficiency?
lack of liquidity, not frequently traded stock,
the efficient market hypothesis has 3 market form?
weak? semi strong? and strong?
Weak Form Efficiency: Prices reflect all publicly available historical data
Semi-Strong Form Efficiency: Prices reflect all publicly available historical data and adjust immediately to new publicly available data
Strong Form Efficiency: Prices reflect all
an interest rate is?
the price for borrowing and lending money
borrowers compete for limited amounts of available capital in capital markets
production opportunities
changes in saving and consumption preferences affects savings
time preferences for consumption
major factors affecting the cost of money
1)production opportunities 2. time preferences for consumption 3. risk 4. inflation
most rates are determined how?
market
supply curve for funds slopes?
upward
at higher interest rates savers are willing to lend more or less
more
demand curve slopes?
downward
the real risk free rate would be
interest rate on st us treasury bond if no inflation risk would occur
the real risk free rate changes with?
economic fundamentals, production opportunities, time preference for consumption
inflation premium = ?
average expected inflation rate over the life of the security
default premium risk is in place b/c? lender will charge what rates?
ther is a chance buyers may not pay off loan. higher interest rate for greater ppl with risk
more liquid bonds would carry what interest rates?
lower interest rates
investors prefer illiquid or liquid assets?
liquid
maturity risk premium means lt or st have higher interest rates?
lt
the term structure of interest rates describes the relationship b/w?
long and st rates
what do we use to est the yield curve
us treasury securities
shape of yield curve: t-bond =?
real risk free rate + inflation premium + maturity risk premium
this term structure theory says the longer end of the curve predicts the future; Upward sloping curve would indicate that future interest rates will increase
(Pure) Expectations Theory -
this term structure theory says Investors prefer to lend short term and require a liquidity premium to lend on the longer end of the yield curve
Liquidity Preference Theory -
this term structure theory says Different institutional investors buy different maturities; the yield curve consists of different markets
Segmented Market Theory -
who controls the money supply
federal reserve board
increasing the money supply, this puts downward pressure on interest rates
expansionary monetary policy
Increasing money supply generally means that future inflation? - this would mean that as short-term rates fall,
increases as well. long-term rates increase: a steepening of the yield curve
Increased government borrowing competes with ? - the rising demand in borrowing crowds out the private sector borrowers - this ?
private sector borrowing. reduces private sector investment spending
Expansionary fiscal policy can lead to
higher interest rates
The larger the trade deficit the higher the borrowing needs thus what happens to interest rates
upward pressure on
during recessions, st interest rates seem to ?
fall
stockholders equity = ?
paid in capital + retained earnings, also total assets - total liabilities
workign capital =?
current assets
net working capital?
current assets - current liabilities
EBIT ?
earnings before interest and taxes
operating income is = to?
sales revenue - operating costs
what is the difference b/w depreciation and amortization
depreciation is applied to capital equipment and tangible assets. amortization is applied to intangible assets such as patents, copyrights, goodwill
EBITdA
earnings before interest, taxes, depreciation, amortization
The amount of cash that could be withdrawn without harming a firm's ability to operate and produce future cash flows
free cash flow
EBIT (1-T) is also called
NOPAT, net operating profit after taxes
what is wrong with book values in the balance sheet?
they can often be economically distorted.
what is MVA
market value added. the difference b/w the market value of firm's equity and book value
EVA is positive if?
after tax operating income exceeds the cost of capital needed to produce this income
EVA makes a good base number to determine
managerial compensation
ratio analysis is a useful tool for?
financial managers, credit analysts, stock analysts
ratio analysis is most commonly done against?
a group of peers, same industry, same circumstances
when using trend analysis you look at?
the evolution of ratios
how are ratios categorized?
Liquidity Ratios
Asset Management Ratios
Debt Management Ratios
Profitability Ratios
Market Value Ratios
what do liquidity ratios tell us?
will the firm be able to pay off its debt on time
which liquidity ratios are used?
current ratio, quick/acid test ratio
what are some asset mgt ratios
inventory turnover ratio, days sales outstanding, total asset turnover ratio
debt mgt ratios help to answer the question?
how leveraged is the company
what are the debt mgt ratios used?
debt ratio, times-interest-earned ratio
what do profitability ratios show?
combined effects of liquidity, asset, and debt mgt on the bottom line of the firm
what are some profitability ratios?
operating profit margin, profit margin
single best measure of performance
ROE-measures the effects of all other ratios
Market value ratios relate ; they also relate
the stock price to earnings (price/earnings or PE ratio)...the book price of common equity to the market price (market/book ratio) - growth stock versus value stock