Higher returns require taking more risk
If you want to earn big returns, you have to take a lot of risk
Risk
-the uncertainty associated with the expected future returns of an asset
-Risk is the part of an asset's price movement that is caused by an unexpected event
Unsystematic risk or firm specific risk (FSR)
Risk related to a surprise event that affects a single company
ex. when Steve Jobs, it effected Apple
The effects of unsystematic risk can be greatly reduced or eliminated through _____
diversification
Systematic risk
Risk related to a surprise event that affects the entire economy and all assets to some degree
ex. Increase in interest rate, declaration of war, terrorist attack
It is not possible to reduce systematic risk through ______
diversification
The CAPM assumes that the expected return on an asset depends only on ______ risk
systematic risk. It is possible eliminate unsystematic risk through diversification
Return on investment equation
ROI = (change in price + dividend) / Purchase Price
Capital gain
An increase in the price of a stock, bond, or other asset
Capital loss
A decrease in the price of a stock, bond, or other asset
Expected return on a risky asset
The rate of return an investor expects to earn on an asset over time based on the asset's risk level
Expected return on the market
The average return of the stock market or the return on a stock market index
In the US, what do investors usually use as a measure of market performance?
S&P 500 and Wilshire 5000 index
Return on the risk free asset
The return that an investor receives on a safe asset that is free from credit risk
Beta - Bi
A measure of an asset's systematic risk
What does Beta indicate?
How responsive a stock's return is to changes in the expected return on the market
The overall stock market is said to have a beta of __
1
If an asset has a beta greater than 1, it is ___ than the market
riskier
If an asset has a beta less than one, it is ____ ____ than the market
less risky
Market risk Premium [E(Rm)-Rf]
The expected return of the stock market minus the risk-free rate
The market risk premium can be thought of as...
the additional return an investor will receive if he purchases an average-risk stock (beta=1) as opposed to a Treasury bill
The market risk premium is an important part of what
CAPM (capital asset pricing model)
Firm Specific Risk (FSR)
A measure of unsystematic risk of an asset
-Extra return (or loss) received by a firm due to some event affecting only that firm
Standard Deviation of Return
Measures the risk of an asset
-Measures how wildly or tightly observed stock returns cluster around the average stock return
-A higher standard deviation means greater risk
-A lower standard deviation means less risk
Estimate the beta for the company below given the following information
Year 1: Stock return = 20%; Market Return = 10%
Year 2: Stock return = 8%; Market Return = 4%
2.0
Estimate the beta for the company below given the following information
Year 1: Stock return = -5%, market return = 5%
Year 2: Stock return = 9%, market return = -9%
-1.0
What stock provides the least amount of risk reduction?
Stocks A and B: Correlation = 1.0
Given the following, what is true?
Stock A: Beta - 1.8, Avg return = 20%
Stock B: 1.2, Avg return = 20%
Stock A outperformed Stock B
Higher the beta, higher the return
A is not as risky but gave as good of a return!
Asset classes in order of risk
1. U.S. Treasury Bills (least risk)
2. U.S. Government bonds
3. Corporate Bonds
4. Large company stocks
5. Small company stocks (most risky)
Capital Asset Pricing Model (CAPM)
Theory used to price risky assets. Focuses on the tradeoff between the risk of an asset and the expected return on that asset
CAPM equation
E(Ri) = (Rf) + (Bi)[E(Rm)-(Rf)]+FSR
basically, risk free rate + beta(Market risk-Risk free rate)
Rarely do we ever do FSR
Calculate the expected return of a company with the following info
Beta = 1.5
Treasury Bill Rate = 2%
S&P averaged return rate = 6%
8%
Calculate the expected return of a company with the following information using CAPM
Beta= 0.8
Treasury Bill Rate = 3%
S&P 500 averaged return rate = 8%
7%
Portfolio
The specific securities (stocks, bonds, mutual funds) owned by an investor
How is the return on a portfolio calculated?
Calculated by multiplying the return on a specific security by the percent of the portfolio the security represents and then adding the result for each security together
ex. x makes up 60% and Y makes up 40% of the portfolio
Rporfolio = (X)(.6) + (Y)(.4)
Investors who hold large portfolios are not concerned about what kind of risk?
Unsystematic risk.
-Investors can use diversification to virtually eliminate firm specific risk
-A well diversified portfolio will have an FSR component that is so small that it is considered to be insignificant
-That is why we say that asset diversificat
CAPM and well diversified portfolios
When using the CAPM equation to calculate the expected return on a well-diversified portfolio, the FSR term is dropped off because diversification has reduced the FSR to virtually zero
-The only uncertainty associated with a well-diversified portfolio is
Well diversified portfolios are identical to one another, besides their what?
Betas
-A portfolio's risk measures the systematic risk of the portfolio
When adding an additional stock to a well-diversified portfolio, the stock's only effect on the portfolio is its effect on the portfolio's ______
Beta
What happens when we add a stock with a greater beta than the portfolio?
It will increase the portfolio's beta
What happens when we add a stock with a beta less than the portfolio?
It will decrease the portfolio's beta
For any investment, beta is the appropriate measure of _____
risk
What is the equation for Alpha
Alpha = Observed return - Expected return
What does it mean when alpha is positive?
The security outperformed the returns expected under the CAPM benchmark
What does it mean when alpha is negative?
The security underperformed the returned expected under the CAPM benchmark
Calculate the alpha of the portfolio:
Beta = 0.6
S&P 500 averaged return = 10%
T-bill rate = 2.0%
Portfolio actual return = 8%
1.2%
Efficient Capital Markets
The current prices of stocks reflect all publically available information and stock prices adjust and react completely, correctly, and almost instantaneously to incorporate new information
-An efficient capital market is a market that is able to efficient
Technical analysis
Analysis of past stock prices and trading volumes
Fundamental analysis
Analysis of the economy, industries, and companies in an attempt to find stocks that are overvalued or undervalued
New information
In an efficient capital market, stock prices change when new information becomes available to the public
Immediate adjustment
-Stock prices adjust to their new correct price within minutes of new information becoming available
-A truly efficient capital market will adjust immediately to new information
Gradual adjustment
-Stock prices adjust to their new correct price within hours of new information becoming available
-If it takes hours for the market to adjust to new information, it is possible to earn great returns on investments that are made quickly after new informat
Random Walk
The future direction of a stock price (up or down) cannot be predicted solely based on past movements, it is impossible to predict short run changes in stock prices, successive price changes are independent of one another.
In the long run stock prices....
move in tandem with a stock's long-term growth of earnings
What statements are correct when referring to the random walk hypothesis and efficient markets?
Stock prices are random, which means that they cannot be predicted base on past performance and stock prices react immediately to new information which causes share prices to change at random
Weak-form efficiency
All past prices of a stock and trading volumes are reflected in today's stock price
-Just past info is included in prices
-Technical analysis cannot be used to predict or beat the market
Semistrong-form efficiency
All public information is reflected in the stock's current price
-Stock reacts quickly to new info which prevents investors from earning abnormal returns
-Neither technical or fundamental analysis can predict or beat the market; however investors could st
Strong-form efficiency
All information, public and nonpublic, is reflected in a stock's current price
-This is the strongest form of market efficiency because it assumes that all information, even if it isn't public information, is included in the stock's price
-Investors canno
What form of market efficiency states that stock prices reflect all information (including private and public)
Strong form
Which form of market efficiency states that stock prices reflect information contained in past stock prices?
Weak form
Behavioral finance
A branch of finance that applies sociology and psychology to human decision-making and behavior patterns
-Modern portfolio theory assumes that all investors are rational, calculating, and intelligent investors who focus on stock prices
-Behavioral finance
Top findings of behavioral finance
1. Investors hate to lose, so they have a tendency to hold onto losing stocks much longer than they should.
2. Investors often overreact or underreact to new information
3. Investors love to look for patterns, and they have a tendency to find them even wh
The Fama and French Study
A study published in 1992 that compared the performance of the return associated with portfolios of stocks that have certain similar characteristics
-Dr. Fama was one of the leading proponents of efficient markets, but this breakthrough research calls int
Findings of the Fama and French study
1. Portfolios of stock with a high book value (BE) to market value (ME) ratio consistently outperformed portfolios with low book value to market value (BE/ME ratios)
2. Stocks with high P/E ratios outperformed stocks with low P/E ratios.
3. Stocks with sm
What have studies shown about mutual funds alphas?
Studies have shown that about half of mutual funds have positive alphas, based on gross returns, and half of mutual funds have negative alphas, based on gross returns.
Gross returns
The returns that investors earn before mutual fund fees are subtracted
Net returns
The returns that investors earn after mutual fund fees are subtracted
The fact that the split is so close to 50-50 (positive and negative alphas on mutual funds) ..
Makes a strong argument that luck is the most likely reason to explain mutual fund alphas
Using gross returns, what was the average mutual fund's alpha?
0%
Using net returns, what was the average mutual fund's alpha?
-1.2%
What have studies shown about mutual funds with positive alphas over a five year period?
Studies have shown that funds with positive alphas over a 5-year period will likely have an average alpha of zero over the next 5-year period
-No group of managers has been able to consistently show abnormally good investment returns
-Just because an inve
In efficient markets, we always expect an alpha of ____ based on gross returns, regardless of past performance
ZERO. If an investor has had a positive alpha over the past 5 years, that investor is still expected to have an alpha of zero for the next 5 years.
It is important to realize that doing well doesn't mean....
That you are more likely to do well again, but it also doesn't mean you are going to do poorly next time
Past performance does not
Predict FUTURE PERFORMANCE, so the expected alpha for mutual funds is always zero
In an efficient market funds with the ______ fees will have the _____ alpha based on net returns
lowest; highest
Why are net returns always less than gross returns?
Because mutual fund fees are deducted to arrive at next returns
Why is the average alpha using net returns negative?
Because of the fees charged by mutual funds
_____ fees result in lower alphas based on net return
Higher
Which of the following statements is correct regarding mutual funds and returns?
a) when dealing with most mutual funds, net returns are smaller than gross returns due to the fees charged by mutual funds
b) mutual funds manage assets for free and get paid
When dealing with mutual funds, net returns are smaller than gross returns due to the fees charged by mutual funds, and in an efficient market, individuals purchasing a mutual fund should always invest in the fund with the lowest fee (typically have great
A mutual fund has a positive alphas using gross returns over the past 5 years. Which of the following statements is correct?
The expected alpha of the mutual fund for the next 5 years will be zero when using gross returns and negative when using net returns.
Bond
A debt financial contract where the issuer of the bond is required to make periodic interest payments and repay the principal at some predetermined point in the future
What does an issuer do with the bond?
They sell the bond. So they receive cash for the bond in exchange for the liability to make periodic interest payments and then repay the principal at maturity
What is it like when a government or corporation issues (sells) a bond?
It is basically the same thing as that organization taking out a loan
What are some other terms for securities that are classified as debt securities?
Bonds, debentures, loans, commercial paper, secured debt, unsecured debt, promissory notes, senior-lien bonds, junior-lien bonds
Bond indenture
A legal agreement between the issuer of the bond and the trustee that represents the investors who own the bonds
Trustee
A major commercial bank that monitors the terms of the bond indenture
-Makes sure that the issuer abides by all of the legal agreements within the indenture
-Collects interest and principal payments from the issuer and distributes those payments to the bo
Principal value, par amount, maturity value, or face value
The amount that the issuer pays the bondholder when the bond matures and the principal payment is due.
-Most corporate and government bonds are issued with maturity values of $1,000
Interest rate or coupon rate (synonymous)
The amount of the annual interest payment on a bond is expressed as a percent of the bond's maturity value
Annual coupon (interest payment)
annual coupon (interest) payment = maturity value x coupon rate
How do we find the payment of a bond?
We multiply the coupon rate X $1000 (unless the maturity value is different. We then take this value and divide by two. We do this because we make payments semiannually when we are paying for bonds
Current market interest rate vs a bond's annual coupon (interest) payments
These two terms are one of the main sources of confusion when dealing with bond valuation problems because they sound so similar and they are both expressed as a percent
Current market interest rate
You can check WSJ every morning to find this. The current market interest rate fluctuates day to day based on economic events and the actions of the federal reserve. This is a variable rate that affects everyone in the economy. The current market interest
A bond's annual coupon (interest) payments
Determined by multiplying a bond's maturity value by the bonds coupon rate
Fixed-rate or fixed-coupon bonds
The interest rate and coupon payments are fixed for the life of the bond, which means the amount of the interest payments do not change
Who takes on the risk of a fixed-rate bond
the bondholder
Fixed-rate par value bond
When a bond is sold for a price equal to its maturity value
What happens when current market interest rate = bond's coupon rate
The bond's price will be equal to the bond's maturity value
Why is a large percent of bonds sold as par value bonds?
Because when the bond is sold, it is easy to set the bond's coupon rate equal to the current market interest rate
What happens once the fixed-rate par value bond is in the primary market?
The bond's coupon rate will stay fixed; however, the market interest rate will vary
Why do many investors sell their bond in the secondary market?
Because they don't hold their bonds to maturity
Fixed-rate discount bond
When the current market interest rate is greater than the bond's coupon rate, the bond's price will be less than the bond's maturity value
Current market interest rate > bond's coupon rate
What happens since the coupon rate is less than the current market interest rate?
The investor pays the issuer of the bond an amount less than the maturity value of the bond
-A bond with a maturity value of $1000 will sell less than $1000
Fixed-rate premium bonds
When the current market interest rate is less than the bond's coupon rate, the bond's price will be greater than the bond's maturity value
Current market interest rate < bond's coupon rate
How to investors invest with fixed-rate premium bonds?
They are likely to purchase a bond at a price higher than the bond's maturity value.
The bond's coupon payments are larger than they should be based on the current market interest rate, so the investor is compensated for the premium paid on the bond with
Floating interest rate structure
bonds whose coupon rate adjusts to the current market interest rate so that the bond is always selling at or near par value
Who retains the interest rate risk in floating-rate bonds?
The issuer.
Why are investors willing to accept significantly lower interest rates on floating-rate bonds than fixed rate bonds?
Because floating-rate bonds are less risky for the investor
What has to be true of a bond that is selling at a premium?
The yield must be less than the coupon rate
What kind of bond requires the issuer to retain the interest rate risk?
Floating rate bonds
Treasury bonds
Debt securities issued by the U.S. government that are considered to be risk-free because they are assumed to have no credit risk IMPORTANT
Why do U.S. government bonds considered to have no credit risk?
Because the U.S government has the power to levy taxes, borrow additional money, and to print money in order to pay obligations
What is the bid/ask spread usually like on U.S. treasury securities?
Very small
What is the treasury yield curve
The treasury yield curve acts as a set of base yield or interest rates from which all other debt securities are priced. U.S. treasury securities are used to determine the risk free rate.
Municipal bonds
Bonds issued by cities, states, or municipalities to raise funds in the form of debt
What kind of bonds are exempt from federal and certain state and local taxation?
Municipal bonds
Why are investors willing to accept lower yields on municipal bonds?
Because compared to corporate and treasury bonds because of the federal income tax exemption
Tax equivalent yield
Tax equivalent yield = r/(1-tax rate)
Calculating the taxable equivalent yield allows investors to relate the return on a municipal bond to the current market ineterest rate and other bonds with comparable maturities
Ways municipal bonds are secured (3)
General obligation bonds
Revenue bonds
Credit enhancement devices
General obligation bonds
Bonds that are secured by the issuers taxing power
Revenue bonds
Bonds that are secured by the revenues from the facility or system constructed with the proceeds of the bonds
Credit enhancement devices
Bonds that are secured with either municipal bond insurance or bank letters of credit
Corporate bonds
Bonds issued by corporations that are typically issued to finance the corporation's long term capital needs and to take advantage of the deduction associated with the interest payments on the debt
What kind of corporations are more likely to issue debt?
capital-intensive and stable industries like manufacturing and electric utilites
Derivative securities
a financial instrument that derives its value from another security. The value of a derivative can be based on the value of a simple security, like a stock or bond, or it can be from the level of an interest rate, interest rate index, or stock market inde
Derivative securities are often more sensitive to
price or yield changes, and they are sometimes more leveraged
This makes derivatives more attractive to hedgers
These same risks create a lot of risk for speculators