Articles

Question 1

CAPM Theory

advantages of Arithmetic average return

Answer 1

• Represents the mean of all the returns that may possibly occur over the investment holding period
• Best estimator of expected (short-term) future returns
• The best gauge of the expected risk premium

Question 2

CAPM Theory

advantages of geometric average return

Answer 2

• when past performance is being considered, the geometric mean (rg) summarizes the annualized rate of return over historical period;
• Best measure of realized (past) returns on an investment;

Question 3

CAPM Theory

Effective Annual Rate - formula

Answer 3

EAR = (1+APR/K)^K-1

Question 4

CAPM Theory

Describe relation between risk and realized return

Answer 4

The more risky asset is (higher volatility (st. dev.)), the higher realized returns

Question 5

CAPM Theory

Conclusions for historical volatility and returns for individual stocks

Answer 5

1. Relationship between size and risk: large stocks have lower volatility
2. Even largest stocks more volatile than S&P
3. No clear relationship between volatility and return
4. Volatility doesn’t explain returns for individual stocks

Question 6

CAPM Theory

Equity risk premium

Answer 6

the difference between the return on equities and the return on a risk-free asset

Question 7

CAPM Theory

Inverse relation between risk premium and price

Answer 7

Risky assets have relatively low price, but a relatively higher expected return

Question 8

CAPM Theory

The risk premium matters because it is central to:

Answer 8

1. Projecting future investment returns - allocation of portfolio investment
2. Calculating a company’s cost of equity capital - Determine the appropriate risk adjusted discount rate
3. Valuing companies and shares - Discount future cash flow
4. Appraising investment projects
5. Determining fair rates of return for regulated utilities

Question 9

CAPM Theory

Market risk premium - formula

Answer 9

Rm-Rf

Question 10

CAPM Theory

Constant-growth model Formula

Answer 10

PV = DIV1/(r-g)

Question 11

CAPM Theory

Relation between price and risk

Answer 11

Higher PV implies less risk - inverse relation between price and risk

Question 12

CAPM Theory

Standard deviation formula and explanation

Answer 12

St.Dev = SQRT(Variance)

This is our measure of risk - volatility
Measured in percent - the same dimension as we gauge returns;

Question 13

CAPM Theory

Coefficient of correlation formula

Answer 13

corr = (Cov AB)/(St.Dev. A * St. Dev B)

Question 14

CAPM Theory

The sense of correlation

Answer 14

Correlation measures how returns move in relation to each other

Question 15

CAPM Theory

Variance of portfolio returns - formula

Answer 15

Variance P = (wa)^2Var a + (wb)^2Var b + 2*(wa * wb * Cor ab * st. dev a * st. dev b)

Question 16

CAPM Theory

Skewness - this is

Answer 16

A measure of symmetry, or more precisely, the lack of symmetry

Question 17

CAPM Theory

Kurtosis - this is

Answer 17

A measure of whether the data are peaked or flat relative to a normal distribution

Question 18

CAPM Theory

Skewness formula

Answer 18

Skewness = ([nju]^3/(st. dev)^3)

[nju]^3 - third moment - asymmetry measure

Question 19

CAPM Theory

Valuation of skewness

Answer 19

Skewness for a normal distribution is zero, and any symmetric data should have a skewness near zero

• Negative values for skewness indicate data that skewed left
• Positive values for skewness indicate data that skewed right

Question 20

CAPM Theory

Kurtosis (formula)

Answer 20

Kurtosis = ([nju]^4/(st. dev)^4)-3

[nju]^4 - fourth moment - asymmetry measure

Question 21

CAPM Theory

Kurtosis valuation

Answer 21

The kurtosis for a standard normal distribution is 3
*for this reason, excess kurtosis is defined so that the standard normal distribution has a kurtosis of K=0

• Positive kurtosis indicates a “peaked” distribution;
• Negative kurtosis indicates a “flat” distribution

Question 22

CAPM Theory

contribution of covariance

Answer 22

Covariance is the contribution of the security to the variance of the well diversified portfolio

Question 23

CAPM Theory 
Leptokurtic distribution (definition)

Answer 23

A distribution with wide tails and a narrow peak (K>3)

Question 24

CAPM Theory

Platykurtic ditribution

Answer 24

A distribution with thin tails and a relatively flat middle (K

Question 25

CAPM Theory | Advantages of Leptokurtic returns

Answer 25

Returns series that are characterized by jumps as opposed to more continuous changes will tend to be leptocurtic * Low probability of extreme outcomes; * Regulatory process dampens moderately deviant returns, forcing them closer to the mean

Question 26

CAPM Theory | Expected portfolio return formula

Answer 26

RE= w1*r1+w2*r2

Question 27

CAPM Theory | Draw co-variance matrix for two assets

Answer 27

http://cmacfm.mazoo.net/WindowsLiveWriter/9cbcdc0f2b05_DB21/almost-covariance-matrix%5B4%5D.gif

Question 28

CAPM Theory | How many assets are necessary for diversification

Answer 28

the gain from diversification comes fast and tapers off relatively fast 10-15 assets enough to capture the major gains from diversification

Question 29

CAPM Theory | Why portfolio variance equals average covariance

Answer 29

* gauges the systematic risk that affects all assets | * Unique risk (individual variance) diversified away

Question 30

CAPM Theory | Diversification -

Answer 30

Strategy designed to reduce risk by spreading the portfolio across many investments

Question 31

CAPM Theory | Unique risk

Answer 31

Risk factor affecting only that firm

Question 32

CAPM Theory | Market risk

Answer 32

Economy-wide sources of risk that affect the overall stock market

Question 33

CAPM Theory | Beta - definition

Answer 33

Marginal contribution to portfolio risk. | The beta of an individual security measures in sensitivity to market movements

Question 34

CAPM Theory | Beta - formula

Answer 34

Bim=(Covarince im)/Variance m

Question 35

CAPM Theory | Beta's valuation

Answer 35

Brf = 0 Bm = 1 - market portfolio perfectly correlated with itself *Stocks with betas greater than 1 tend to amplify the overall movements of the market; *Stocks with betas between 0 and 1 tend to move in the same direction as market, but not as far

Question 36

CAPM Theory | Inverse relation between price and risk

Answer 36

the larger the systematic risk is, the lower is the price of the asset

Question 37

CAPM Theory | two implications from diversification

Answer 37

1. only systematic risk determines expected returns | 2. Value additivity - Investors that can diversify on their own account will not pay extra for firms that diversify.

Question 38

CAPM Theory | Ranking by Mean Variance criterion (the matrix)

Answer 38

C:\Users\Admin\Documents\Petrovics\sse\sse\Year 2\FE\Ranking by MV Criterion.JPG

Question 39

CAPM Theory | the portfolio opportunity set

Answer 39

http://analystnotes.com/graph/portfolio/SS12SBsubd1.gif

Question 40

CAPM Theory | Minimum Variance Portfolio (Formula)

Answer 40

Xmin(S) = http://images.slideplayer.com/9/2576471/slides/slide_21.jpg

Question 41

CAPM Theory | Describe simply process for short selling

Answer 41

Borrow a stock, sell it to cash in and then restore it to the original owner by buying back.

Question 42

CAPM Theory | Two fund separation theorem

Answer 42

Assumptions: Homogeneous expectations Same lending and borrowing rate for all investors Theorem: Each investor will choose the same combination of risky assets. The optimal combination of risky assets for any investor can be determined without any knowledge about the investors preference toward risk and return.

Question 43

*CORP.FIN.* | Types of dividends

Answer 43

Regular d. Special d. (regular + bonus) Stock split d. (pay dividends as shares) Liquidating d. (sell assets - then pay)

Question 44

*CORP.FIN.* | Types of share repurchases

Answer 44

``` Open market repurchase (95% of all rep.) Tender offer (an offer to all s/h to buy back a specified amount of shares at a specified price) Dutch auction (a share repurchase method as an auction) Targeted repurchase (direct negotiation with major s/h) ```

Question 45

*CORP.FIN.* | MM (1961) dividend irrelevance proposition

Answer 45

In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price (or shareholder wealth). i.e., investors are indifferent between: 1. Free cash flow being paid out as a dividend 2. Free cash flow being used to repurchase shares 3. Shares being issued to pay a dividend larger than free cash flows

Question 46

*CORP.FIN.* | ROE>

Answer 46

ROE Negative NPV projects -> pay higher div. to increase company value; ROE>r(e) -> Positive NPV projects -> pay less div. (reinvest more) to increase company value;

Question 47

*CORP.FIN.* | Explain lifecycle theory

Answer 47

Young firms: a lot of profitable investment opportunities (i.e. NPV>0) and a need for financing -> pay more in dividends. Mature firms: sufficient earnings to finance future projects, fewer profitable investment opportunities-> pay more in dividends

Question 48

*CORP.FIN.* | DeAngelo (2008) Proposition

Answer 48

DeAngelo argues that empirical evidence is most consistent between agency costs and capital raising costs: -To pay dividends -> increases probability of needing to raise capital ->raising capital is costly (particularly due to valuation uncertainty and adverse selection) -> ‘wasted’ value - Not paying dividends -> increases retained earnings -> increases agency costs (misappropriation, intentional or unintentional behavioural biases) -> ‘wasted’ value

Question 49

*CORP.FIN.* (CORPORATE PAYOUT POLICY + lecture slides) Reasons for low dividend (5) Reasons for high dividend (4)

Answer 49

Reasons for low dividends 1) Good investment prospects (positive NPV), as you have more retained earnings left; 2) Personal taxes (dividends are more costly than capital gains); 3) Costs of financial distress (it is better to sit on cash, than deal with fin. distress due to defaulting on debts) 4) High issuance costs (equity issue is costly, so it is better to sit on cash) 5) Clientele effect (for each person it is individual how much is it taxed on the div or capital gains) Reasons for high dividends 1) lack of good investment prospects (only zero/negative NPV projects available), e.g. mature firms; 2) Information assymetry (dividends signal firm's future performance); 3) to lower agency costs (less is left for managers) 4) Bird in hand theory (лучше синица в руке, чем журавль в небе - if highly uncertain investments, better to pay out as div) 5) Clientele effect (for each person it is individual how much is it taxed on the div or capital gains);

Question 50

*CORP.FIN.* What capital structure will maximize the value of the firm? MM Proposition

Answer 50

Modigliani and Miller’s answer is that under a set of conditions this question is irrelevant because capital structure does not affect the value of a firm. In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.