Factors Flashcards
(31 cards)
What are Value stocks?
Stocks with high book to market ratio.
or, stocks which have very low market price
What are growth stocks?
Stocks with low book to market ratio.
What is a value growth strategy?
An investment strategy that longs value stocks and shorts growth stocks.
How are risk premiums affected by macroeconomic factors?
It is the shock (i.e. unexpected changes) to a factor that matters
How different assets perform during low economic growth?
Risky assets like equities perform poorly.
Low risk assets like bonds, especially government bonds, perform well during periods of slow growth.
And vice versa.
What works best during recessions?
Government bonds perform best during recessions, because of flight to safety, demand and price increases
How inflation affects returns?
Generally bad for both stock and bond prices
Inflation lowers real bond returns
How volatility affects returns?
Volatility increases»Risk Increases»Discount Rate Decreases»Price decreases
Also, leverage ratio (asset to equity) increases during this time as market equity value falls
Negative relationship between stock returns and volatility
How productivity shocks affect returns?
Affects firm O/P. Correlation between productivity shock and stock returns are relatively high.
What are dynamic stochastic general equilibrium (DGSE) models?
These are new macro models, which indicate that economic variables change over time due to action of agents (eg. governments, firms, consumers, banks, etc.), technologies (and their impact on how firms produce goods and services) and the way that agents interact (ie markets)
What are the seven shocks specified by Smets and Wouters in 2007 that affect the business cycle?
productivity, investment, preferences, inflation, monetary policy, government spending and labor supply
Demographic Risk
Shock to labor output
Overlapping generation models
These include demographic risks as a factor affecting investor returns, workers earn income and save during young and middle ages, and retired workers disinvest.
How age of population affect returns?
As average age of population increases, risk aversion increases, and required equity risk premium also increases
Political or sovereign risk
Affects both developed and underdeveloped countries
How to manage volatility risk?
- Invest in less volatile assets.
- Invest in OTM Put options (or other volatility protection)
How to earn volatility premium?
Sell volatility protection, but, during crashes, sellers of volatility protection suffer large losses
Relationship between Market Risk Premium and Volatility
E(Rm)-Rf=gamma X Variance
Gamma is the average investors risk aversion, positive in theory, but can also be negative or zero
What are the factors in a FAMA French Model?
Market Risk Factor (MKT) (Rm-Rf)
Size effect (SMB) (Return of small mkt cap>Return of big mkt cap)
Value/Growth (HML) (Return of value>Return of growth)
HML and SMB Betas
Are 0 on average
Size effects are disappearing, why is that?
- Data mining: Although data used in the fama french model showed a reliance on SMB factor, this was not the case in out of sample data
- Investor actions: Investors exploited the market to ensure that SMB factor did not give any returns
What are the theories of Value Investing?
- Rational Theories of the Value Premium
- Behavioral theories of value premium
What is the rational theory of value premium?
Rational theories argue the value premium exists because value stocks are riskier, especially during economic downturns, and investors are compensated for bearing this risk. The premium reflects risks tied to factors like labor income and investment growth, and only those able to withstand “bad times” can benefit from holding value stocks.
Behavioral theories of value premium
Behavioral theories suggest the value premium arises because investors overreact to past growth and are loss averse, causing growth stocks to become overpriced and value stocks underpriced. As a result, value stocks outperform not due to higher risk, but because of persistent investor biases and underreaction to value stocks’ prospects.
