Flashcards in FINC326 CAPM/Stock Valuation Deck (40)
Total return has two parts
Expected return and unexpected return
Total return - Expected return = Unexpected return
Suppose Intel were to announce that earnings for the quarter just ending were up by 40 percent relative to a year ago. Do you expect that the stock price would rise or fall on the announcement?
The answer is that you can’t really tell. Suppose the market was expecting a 60 percent increase. In this case, the 40 percent increase would be a negative surprise, and we would expect the stock price to fall. On the other hand, if the market was expecting only a 20 percent increase, there would be a positive surprise, and we would expect the stock to rise on the news.
systematic risk, give example
Risk that influences a large number of assets. Also called market risk. uncertainties about general economic conditions, such as GDP, interest rates, or infl ation, are examples of systematic risks
unsystematic risk, give example
Risk that influences a single company or a small group of companies. Also called unique or asset-specific risk.
Ex the announcement of an oil strike by a particular company will primarily affect that company and, perhaps, a few others (such as primary competitors and suppliers).
What is connection b/t Unsystematic risk and diversification???
Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.
In fact, the terms diversifiable risk and unsystematic risk are often used interchangeably.
What is connection b/t systematic risk and diversification???
CANNOT be eliminated by diversification becuz by definition, a systematic risk affects almost all assets. As a result, no matter how many assets we put into a portfolio, systematic risk doesn’t go away.
systematic risk principle
The reward for bearing risk depends only on the systematic risk of an investment.
The expected return on an asset depends only on
its systematic risk.
Measure of the relative systematic risk of an asset. Assets with betas larger (smaller) than 1 have more (less) systematic risk than average.
What does beta of 2 mean????
the asset has twice as much systematic risk as an average asset.
Twice as risky/sensentive/volitile as the market
If SP500 goes up 1% then the dependent variable (expected/required return) goes up by 2
Microsoft is half as risky as the market. What's its beta?
expected return, and systematic risk relationship
Because assets with larger betas have greater systematic risks, they will have greater expected returns.
How do you calculate a portfolio beta?
the sum of Portfolio weights times beta for each stock
beta of risk-free asset?
expected return equals
(expected price - today's price ) / today's price
A security is said to be overvalued when
if its price today is too high given its expected return and risk
Beta of risk-free asset is
reward to risk ratio
Asset A has a risk premium of 7.50 percent per “unit” of systematic risk
Help to see which asset is better.
BUT The reward-to-risk ratio must be the same for all assets in a competitive
fi nancial market.
What should today's price do to make a asset that is currently plotted above the Security Market Line be back on the line?
To lower the expected return for Asset C, its price today must increase until the reward-to-risk ratio for Asset C plots exactly on the line.
Above the line means return is high, so price is low so its undervalued
What should today's price do to make a asset that is currently plotted below the Security Market Line be back on the line?
To increase the expected return for Asset D, its price today must fall until the reward-to-risk ratio for Asset D also plots exactly on the line.
Below the line means return is low, so price is high so its overvalued .
how does inflation increase affect SML?
the line will shift paraellel
there's a shock in market, people want compenstation. what happens to SML
Constant div growth
Po = D0 ( 1+g) / k-g
Po = D1 / k-g
D4 = Do (1+g) ^ 4
D4 = D1 (1+g) ^ 3
sustainable growth rate
A dividend growth rate that can be sustained by a company’s earnings.
Earnings retained within the firm to finance growth.
Proportion of earnings paid out as
Proportion of earnings retained for reinvestment.
ni / equity
Price / EPS