Class 2 Flashcards
What is idiosyncratic risk?
If you want to reduce idiosyncratic risk what do you do?
Keep adding stocks to your portfolio
- value-weighted
-equal weighted
What does CAPM stand for?
Capital Asset Pricing Model
What is CAPM?
it is a financial model that helps in determining the expected return on an investment given its risk.
The model is based on the relationship between risk and return in financial markets
How do you calculate the expected return on an investment in the CAPM framework?
risk-free rate + risk premium which is proportional to the asset’s beta coefficient (B) x the market risk premium
E(Ri) = Rf + βi (E (Rm)-Rf)
E(Ri) = expected return on investment
Rf = risk free rate
Bi = beta investment
E(Rm) = expected return on the market
(E(Rm) - Rf) = market risk premium
What is risk-free rate? (CAPM)
the theoretical rate of return on an investment with 0 risk, typically approximated using the yield on government bonds
What is Beta (B)?
Beta measures the volatility or systematic risk of an investment relative to the market as a whole.
B=1 (assets price moves perfectly with market)
B>1 higher volatility
B<1 lower volatility
What is market risk premium?
the difference between the expected return on the market portfolio and the risk-free rate. It represents the additional return investors require for bearing the risk of investing in the overall market.
What is risk?
uncertainty of return (variance)
Does risk-free rate of return Rf have variance?
no
What does systematic mean?
relates to the whole market
What is diversifiable risk?
unique to firm or project eg. strikes and strategy error
Cost of equity formula
Ke = Rf + Be [E(Rm) - Rf]
Ke: cost of equity
Rf: current yield on government securities with same maturity as company’s projects: typically the long term rate
E (Rm): use market premium (stocks-bonds) of about 7 percent pa
Be: calculate from historical data
What issue would you have if you buy a stock for which there were no disclosures about the firm?
lemons problem
What is the efficient market hypothesis? EMH
EMH argues that security prices in active secondary markets:
-are fair (they incorporate all available info and are consistent with securities expected return)
-will change in response to new info which arrives randomly, and therefore changes in price will also be random
Why don’t groups of investors subscribe to the EMH?
because they believe that markets provide opportunities for excess returns
What is weak form efficiency?
prices reflect all info contained in historical prices
(so chartists, as a group, should not achieve abnormal returns)
What is semi-strong form efficiency?
prices reflect all public info
(so fundamental analysts, as a group, should not achieve abnormal returns)
What is the pump and dump efficient market hypothesis?
The Huang Case
Facts?
Huang worked for capital one
he looked at credit card data to see which retailers were doing well in real time.
he bought the stock ahead of earnings announcements and turned thousands into millions in a short time (he ran away to china without extradition).
What are the federal securities laws?
securities act of 1933
securities exchange act of 1934
Investment company act of 1940
investment advisors act of 1940
Trust indenture act of 1939
Sarbanes-Oxley act of 2002
Dodd-Frank Act of 2010
Jobs Act of 2012
