Chapter 6: Risk and Return

Question 1

Intrinsic value of a company

Answer 1

Preset value of it’s expected future free cash flows discounted at the weighted average cost of capital

all else holding equal higher risk increases WACC (reducing the firm’s overall value)

Question 2

risk aversion

Answer 2

a higher level of risk aversion leads an investor to require a higher rate of return as inducement to buy riskier securities

Question 3

Dollar return

Answer 3

= amount to be received less amount invested

not very meaningful
- need to know scale of investment and timing of return to know if return was good

Question 4

Rates of return

Answer 4

= dollar return / amount invested

standardizes the dollar return to consider annual return per unit of investment

Question 5

Risk

Answer 5

“Exposure to an unfavorable event”

analyzed in two ways for asset risk
- considering each asset in isolation
- as part of a collection of assets (portfolio)

Question 6

Asset’s stand-alone risk

Answer 6

Risk an investor would face if they held only this one asset

Question 7

Discrete probability distribution

Answer 7

a list of all possible events/ outcomes, with a probability assigned to each event (total probabilities must sum to 100%)

can be used to calculate expected risk and return

Question 8

Payoff matrix

Answer 8

Shows the various potential scenarios and lists the:
- probability of the scenario
- market rate of return given the scenario
- expected return (probability x return)
- standard deviations:
- deviation from expected return (market rate -1)
- Squared deviation
- probability of scenario x squared deviation
sum of this last one = variance

Question 9

Weighted average of outcomes

Answer 9

sum of all (possible outcomes * probability of occurrence)

Question 10

R-hat

Answer 10

r

expected rate of return
mean of the probability distribution

= sum of all (probability potential outcome * return if outcome returns)

Question 11

measure of tightness of probability distribution

Answer 11

standard deviation (represented by signma)

larger = wider dispersal from expected value

Question 12

Calculating standard deviation

Answer 12

square root of sum of all (probability of occurrence * (deviation between expected rate and possible outcome rate squared)

Variance is the calculation before taking the square root

standard deviation gives an idea of how far above or below the expected value an actual value is likely to be

SAMPLE standard deviation denoted by s

Question 13

Continuous probability distributions

Answer 13

probability distributions that have an infinite number of possible outcomes, often shown as a curve. Area under the curve must = 100%. can only show the probability that an outcome will be between two outcomes, less than or equal to or greater than or equal to.

more used than discrete distribution

normal distribution often used

common to use historical data to estimate standard deviation

Question 14

normal distribution

Answer 14

bell-shaped, symmetrical continuous probability distribution

actual return will be within +/- 1 standard deviation of the expected return 68.26% of the time

Question 15

use of historic data to estimate standard deviation

Answer 15

historical standard deviation may be used as an estimate of future variability (variability often repeated)

it is INCORRECT to use the historic average return to estimate expected rate of return

Question 16

annualize monthly standard deviation

Answer 16

multiply the monthly standard deviation by the square root of 12

Question 17

historic trade off between risk and return

Answer 17

highest average returns also have highest standard deviations (widest ranges of returns)

Question 18

Weight of an asset in a portfolio

Answer 18

the percentage of the portfolio’s total value that is invested in that asset

weight more meaningful than dollar value

total weights sum to 1

Question 19

Actual return on a portfolio for a particular period

Answer 19

weighted average of the actual return in the stocks in the portfolio

= sum of all (weight * return) for each stock

Question 20

Average portfolio return over a number of period

Answer 20

weighted average of the stock’s average return

= sum of all (weight * average return) for each investment

Question 21

why might adding a risky asset to a safer asset reduce risk

Answer 21

(combined portfolio standard deviation lower than the less risky asset’s standard deviation)

changes in returns balance out

Question 22

Correlation

Answer 22

tendency of two variables to move together

measured by the correlation coefficient

range from +1 (two variables move in perfect sych) to -1 (two variables move in directly opposite directions). 0 means variables are completely independent

Question 23

Estimating correlation from sample data

Answer 23

called “R”

sum of all (actual return stock 1- average return stock 1) * (actual return for stock 2 - average return for stock 2)
DIVIDED BY
square root of (sum of all (actual return stock 1- average return stock 1) squared) *(sum of all (actual return for stock 2 - average return for stock 2)squared)

CORREL in excel

negative correlation = moving in opposite directions

Question 24

correlation and the benefits of diversification

Answer 24

if returns for stocks have a negative correlation investing in both may reduce volatility of the portfolio (makes portfolio’s standard deviation less than the weighted average of the individual stock’s standard deviation)

Question 25

zero risk portfolio

Answer 25

where correlation between stock 1 and 2 is -1 such that the deviations from the mean completely cancel each other out. expected return = weighted average of stock's expected return

Question 26

Correlation and risk

Answer 26

- for correlation between -1 and +1 the porfolio's standard deviation is less than the weighted average of the stock's standard deviation

Question 27

effects of portfolio size on portfolio risk for average stocks

Answer 27

The risk of a portfolio consisting of stocks declines (approaching a limit which is market risk) as the number of stocks in the portfolio increases.

Question 28

market portfolio

Answer 28

a portfolio consisting of all shares of all stocks

Question 29

Market risk

Answer 29

stock risk that can not be eliminated even with a well diversified portfolio risk remaining after diversification: nondiversifiable or systematic risk measured by the beta coefficient (beta risk) stems from factors that affect most firms (war, inflation, recession, interest rates)

Question 30

Diversifiable risk

Answer 30

that part of a security's total risk that is associated with random events not affecting the market as a whole. Risk that can be eliminated by diversification aka company specific risk - from events that are unique to a particular firm and "random" so far as the portfolio is concerned

Question 31

importance of diversification

Answer 31

"Almost half of the risk inherent in an average individual stock can be eliminated if the stock is held in a reasonably well- diversified portfolio, which is one containing 40 or more stocks in a number of different industries.

Question 32

Capital asset pricing model

Answer 32

CAPM one way to measure the risk of an individual stock 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 reflecting only the risk remaining after diversification [ ] = items in subscript r[i] = r[RF]+b[i] (r[M] - r[RF])

Question 33

relevant risk

Answer 33

the relevant risk of a stock is it's contribution to a well-diversified portfolio's risk (much smaller than stand-alone risk)

Question 34

Relevant risk of an individual stock per CAPM

Answer 34

the amount of risk the stock contributes to the market portfolio (containing all stock)

Question 35

Beta coefficient

Answer 35

measure of risk beta coefficient for stock i = ( standard deviation of stock i's return / standard deviation of the market's return) * correlation between stock i's return at the market return estimated using past data (4-5 years of monthly data or 52 weeks of weekly data) Estimate may vary by analyst - analysts may calculate their own or average published betas proper measure of relevant risk in a well-diversified portfolio

Question 36

beta coefficient meaning

Answer 36

stock with a high deviation will tend to have a high beta: other things held constant the stock contributes a lot of risk to a well diversified portfolio (destabilizes) a stock with a high correlation with the market will also tend to have a large beta; be risky (high correlation does not help diversification)

Question 37

beta of a portfolio

Answer 37

the weighted average of the beta values of all the stocks in the portfolio (weighted by the proportion of the stock) = sum of all (weight of stock * beta of stock)

Question 38

variance and beta relationship

Answer 38

variance of a well diversified portfolio is approximately equal to the product of its squared beta and the market's variance

Question 39

standard deviation and beta

Answer 39

(only considering portfolios with positive betas) the standard deviation of a well-diversified portfolio is approximately equal to the production of the portfolio's beta and the market standard deviation a portfolio with: - beta > 1 will have a larger standard deviation (more risk) than the market - beta = 1 will have the same standard deviation (risk) as the market - beta < 1 will have a smaller standard deviation (less risk) than the market

Question 40

contribution of a single stock to portfolio standard deviation

Answer 40

(in a well diversified portfolio) each stock contributes weight of stock * beta of stock* standard deviation of market

Question 41

Beta, Key points:

Answer 41

- beta determines how much risk a stock contributes to a well-diversified portfolio - average of all stock's betas = 1 (beta of the market = 1) because the market return is the average of all stock's risk - stock with beta >1 contributes more risk than does the average stock and a stock with beta < 1 contributes less - stocks with more risk (higher beta) tend to do better than average stock when market does well and worse than average when market does poorly - most stocks have betas between 0.4 and 1.6

Question 42

Ex ante model

Answer 42

variables represent before-the-fact expected values

Question 43

beta coefficient expectation

Answer 43

beta coefficient used by investors should reflect the relationship between a stock's expected return and the market's expected return in the future beta is calculated using data from the past, assuming the stock['s risk will be the same in the future

Question 44

Alternate calculation of beta

Answer 44

Beta of stock i = covariance of stock i and the market / variance of the market formula for slope of a regression line if stock's return on y axis and market portfolio's return on the x axis Covariance of stock i and the market = correlation of stock i and the market * standard deviation stock i * standard deviation of the market

Question 45

Using a regression line to calculate beta

Answer 45

stock's returns on y axis market's returns on x axis regression line for formula y= mx+b+ error gives estimate of beta using trendline in excel shows regression equation and Rsquared estimated beta is the m part of the mx+b function (slope) can just calculate using excel's slope formula

Question 46

R squared value

Answer 46

measures the proportion of variation that is explained by the regression equation R squared of 1 = all points lie exactly on the regression line (all variation in the y variable explained by the x variable)

Question 47

What the R squared value means for a beta estimate

Answer 47

R squared gives the percentage of variation in the stock return that is explained by the market return

Question 48

Risk premium on "the market"

Answer 48

= require rate of return on the market portfolio - risk free rate of return the additional return over the risk-free rate (US Treasury bonds) required to induce an average investor to invest in the market portfolio (as opposed to purchasing risk-free securities) aka equity premium or equity risk premium primarily depends on average investor's degree of risk aversion, higher when investors are more risk averse usually ranges 4%-7%

Question 49

Risk premium on stock i

Answer 49

= Risk premium on "the market" * beta of stock i the extra rate of return an investor requires to invest in a particular stock

Question 50

Required return on stock i

Answer 50

generally conceptualized as the risk-free rate + the risk premium needed to induce the investor to hold the stock

Question 51

Security market line

Answer 51

represents in graphical form the relationship between the risk of an assets as measured by its beta and the required rates of return for individual securities require rate of return for stock i = risk free rate of return + (beta coefficient for stock i * risk premium on the market) aka = risk free rate + risk premium for stock i SML

Question 52

Graphing SML

Answer 52

Y axis: required rates of return x axis: risk, measured by beta y-axis intercept = portfolio with a beta of 0 (riskless) required return = risk-free rate slope reflects degree of risk aversion in the economy (average investor) - greater average aversion to risk = steeper slope (= greater risk premium on all stocks = higher required rate of return on all stocks) so gives (for different stocks) the required rate of return given the beta (and a given risk free return and required return on market)

Question 53

Impact on required return: changes in the risk-free rate

Answer 53

change in risk-free rate will not necessarily cause a change in market risk premium so required rate of return only changes identically to risk-free rate

Question 54

Impact on required return: changes in risk aversion

Answer 54

changes in risk aversion change the slope of the security market line. Greater risk aversion = steeper slope increased risk aversion = increased market risk premium (slope of SML line)

Question 55

Impact on required return: changes in a stock's beta coefficient

Answer 55

moves the point for required return along the given SML line given risk aversion + a positively sloped SML the higher a stock's beta the higher it's required rate of return firm can change its beta through changes in composition of assets and through use of debt

Question 56

Expected rate of return on a portfolio

Answer 56

weighted average of the expected returns on individual stocks = sum of (weight of stock i * expected return on stock i ) for all stock's held

Question 57

Required rate of return on a portfolio

Answer 57

weighted average of the required returns on individual stocks = sum of (weight of stock i * required return on stock i ) for all stock's held

Question 58

required return on a portfolio expressed using beta

Answer 58

= risk-free rate of return + (beta of the portfolio * risk premium on the market)

Question 59

beta of a portfolio

Answer 59

weighted average of beta of individual stocks

Question 60

evaluating portfolio managers

Answer 60

key is evaluating the portfolios return against the return the manager should have made given the risk of the investments

Question 61

intrinsic value vs market price

Answer 61

intrinsic value incorporates all relevant available information about expected cash flow and risks market prices are based on investors' selected and interpretation of information when market price is lower than intrinsic value there is opportunity for rate of return in excess of required return (which drives up price, and drives down yield)

Question 62

Market equilibrium

Answer 62

the condition under which the intrinsic value of a security is equal to its price; when a security's expected return equals its required return aka equilibrium When a security's price is below its intrinsic value demand increases (people buy) and drives the price up (and yield down) until expected = required return when a security's price is above its intrinsic value demand decreases (people sell) which drives the price down (and yields up) until expected = required return

Question 63

market equilibrium equation

Answer 63

Expected return = required return or market price = intrinsic value

Question 64

Efficient markets hypothesis

Answer 64

asserts that: - stocks are always in equilibrium (changes in value are adjusted to so quickly that there isn't time to take advantage before the change) - it is impossible for an investor to consistently "beat the market" by getting a higher return than is justified by the stock's risk assumes that all important information regarding a stock is reflected in the price of that stock

Question 65

Three forms of the Efficient Market Hypothesis

Answer 65

Weak-form semistrong-form strong-form

Question 66

Weak-form EMH

Answer 66

asserts that all information contained in past price movements is fully reflected in current market prices means that information about recent trends in stock prices is of no use in selecting stocks implies that any information that comes from past stock prices is too rapidly incorporated into the current stock price for opportunity to exist

Question 67

semistrong form of EMH

Answer 67

States that market prices reflect all publicly available information implies it would do no good to exam annual reports/ other published data because market prices would have adjusted to any public information when the information became public investors should expect to earn returns commensurate with risk and only do better or worse by chance stock prices will only respond to new information if the information is unexpected

Question 68

strong-form EMH

Answer 68

states that current market prices reflect all pertinent information, whether publicly or privately held, making it impossible for even insiders to earn consistently abnormal returns

Question 69

market bubbles

Answer 69

strings of events where: 1. prices climb rapidly (to heights previously considered unlikely) 2. volume of trading is much higher than in the past 3. many new investors (speculators) enter the market 4. prices suddenly fall precipitously leaving many investors with huge losses past experience suggests that in the height of these booms market prices far exceed intrinsic values (aka the market is not efficient)

Question 70

How do people make money when a market bubble bursts?

Answer 70

bet against an overvalued market if everyone did this it would cause market prices to retreat to intrinsic values quickly

Question 71

strategies for profiting from a failing market

Answer 71

- sell stocks (or the market index itself) short - purchase a put option or write a call option - take a short position in a futures contract on the market index

Question 72

selling a stock short

Answer 72

selling a share of stock that has been borrowed from the broker receive cash but owe the share but when the price of the share falls can buy at the lower price and return to the broker and make the difference in profit (if price goes up would lose the increase)

Question 73

put option

Answer 73

the option to sell a share at a fixed strike price so if stock price falls below strike price can buy at lower price and sell at higher strike price (if put expires before stock price falls the money spent on the put is a loss)

Question 74

writing a call option

Answer 74

selling the obligation to sell a share (when called upon) at a given strike price if price stays below strike price the sale is all profit if price rises above strike price: seller must buy a share at the new higher price and sell it at the lower price, resulting in a net loss (including consideration of the call option price) (generally settled for cash and not actual shares)

Question 75

short position in a futures contract

Answer 75

obligated to sell a share at a fixed price if market price falls below specified price: profit from buying a share at market price and selling at the higher fixed price if market price increases: loss from buying share at higher price and selling it at lower fixed price (generally settled for cash and not actual shares)

Question 76

problem with market bubble puncturing strategies

Answer 76

(puncturing = capitalizing on an overvalued market & thus driving it back to equilibrium) may take a long period of time for market to return to intrinsic value and cost of strategies employed could be prohibitive

Question 77

why negative bubbles don't persist

Answer 77

no potential for negative cash flows. Investors buy stock at too low market price and hold it until price eventually increases. losses are paper-only and not cash

Question 78

book-to-market ratios

Answer 78

B/M ratios book value of equity / market value of equity companies with high B/M rations tend to have higher returns than predicted by CAPM

Question 79

long-term reversals

Answer 79

studies show that portfolios of stocks with poor past long-term performance tend to do slightly better in the long-term future than predicted by CAPM (and vice versa)

Question 80

momentum

Answer 80

stocks with strong performance in the short-term past tend to do slightly better in the short-term future than CAPM predicts stocks with weak performance in the short-term past tend to do slightly worse (?) in the short term-future than CAPM predicts

Question 81

Fama-french portfolios

Answer 81

Portfolios of similarly sized companies based on the company's size as measured by the market value of its equity and the company's book-to-market ratio returns tend to increase as B/M ratio increases

Question 82

Fama-french three-factor model

Answer 82

three factors for determining required return - excess market return (market return minus risk-free rate) - size (return on a portfolio of small firms - return on a portfolio of big firms) - book-to-market effect (the return on a portfolio with high book-to-market ratio minus return on portfolio with a low B/M ratio) accounts for many of the major violations of the efficient market hypothesis useful in identifying the market's reaction to news about a company

Question 83

SMB portfolio

Answer 83

Small minus big portfolio all actively traded stocks ranked by size and split into two portfolios: small stocks and big stocks return on small portfolio - return on big portfolio = SMB portfolio designed to measure the variation in stock returns caused by size effect

Question 84

HML portfolio

Answer 84

High minus low portfolio all stocks ranked according to their book-to-market ratios 30% of stocks with highest ratios = H portfolio 30% of stocks with lowest ratios = L portfolio return of H portfolio - return of L portfolio = HML portfolio

Question 85

using the fama-french model

Answer 85

can decompose an actual change in stock price to see what is explained by the environment (covered by the market, the SMB and HML portfolios) and what is explained by the company's actions. not as useful to estimate the required return on a stock (no well-accepted link provided between risk and required return)

Question 86

unexplained return

Answer 86

= actual return - predicted return

Question 87

meaning of b/m ratio

Answer 87

High BM ratio = low market value = lenders reluctant to extend credit = higher risk = higher return required

Question 88

Behavioral finance

Answer 88

a field of study that analyzes investor behavior as a result of psychological traits. Assumes that investors do not necessarily behave rationally and instead focuses on irrational but predictable financial decisions

Question 89

potential behavioral explanations for market bubble creation

Answer 89

- overconfidence (people are overconfident in their own abilities relative to those of others) - anchoring bias - herding

Question 90

self-attribution bias

Answer 90

people's tendency to ascribe their successes to their own talents and blame their failures on bad luck repetition leads to conclusions of talent

Question 91

hindsight bias

Answer 91

tendency of people to believe, after an event has occurred, that they predicted the past better than they actually did (leads to thinking can predict the future)

Question 92

Anchoring bias

Answer 92

occurs when predictions of future events are influenced too heavily by recent events (vs all pertinent events including those past)

Question 93

Herding behavior

Answer 93

when groups of investors emulate other successful investors and chase asset classes that are doing well creates excess demand for asset classes, causing price increases that can induce additional herding behavior being part of a large group may make the penalty for being wrong bigger than the reward for being correct

Question 94

loss aversion

Answer 94

a behavioral phenomenon occurring when investors dislike a loss more than they like a gain of the same amount preference of a sure gain over a higher risky gain preference of a higher risk of loss over lower sure loss

Question 95

operations relationship to stock market

Answer 95

because every project contributes to the size, timing and risk of the company's cash flows the relevant risk and expected return of any project must be measured in terms of its effect on the stock's risk and return

Question 96

Use of CAPM for managers

Answer 96

Can be used to estimate the required return on a company's stock, which will be the required return of any projects undertaken