Introduction to Financial Markets Part 2

Question 1

Returns

Answer 1

Expected vs actual returns for asset A
What we can expect to earn from holding asset A over a given period.
The actual return could be higher or lower than this expectation
Could base expectation on average past returns or use more detailed info like the firm’s prospects

Question 2

Calculating returns

Answer 2

when considering monetary returns, need to consider both dividend income and capital gains.
Dividend income could be zero
Capital gains could be negative

Question 3

Summary statistics

Answer 3

These provide a summary of the characteristics of a data series, e.g the stock price for Apple over the last 10 years. They include the mean, standard deviation, highest/lowest value, correlation:
1. Mean: gives an average value over a time period
2. Variance and Standard deviation: measure of spread and volatility, hence provides a measure of risk.
3. Covariance and correlation: measures how different series are related, e.g. returns of different assets are related.
1 and 2 are important for ascertaining asset characteristics, 3 for portfolio diversification.

Question 3

Calculating the standard deviation of returns

Answer 3

Variance is a measurement of spread, measuring the variability or volatility from the mean. This volatility provides an indication of the risk an investor may be exposed to when purchasing an asset.
A large variance indicates large deviations from the mean, while the opposite is true of a small variance.
Not enough to just look for average returns
The standard deviation is the square root of the variance.

Question 3

Risk and return

Answer 3

• NPV and other valuation techniques need cost of capital
  Risk-adjusted discount rate; required return
  Determined by ‘the market’

Question 4

Introduce risk into the valuation process

Answer 4

How to measure risk
How to estimate the required rate of return for a given level of risk
How risky are stocks and what have their returns been historically
Is the stock market ‘efficient’
How to measure the performance of portfolio managers

Question 4

Forecasting financial Crises

Answer 4

Describing the Crisis using such a narration is not helpful for us to understand and forecast the next financial crisis.
Global Financial Crisis of 2007-08: A Narrative:
Both housing and stock markets boomed and collapsed
Banks who wrote many mortgage loans went bankrupt
Asset backed securities-backed by income yielding assets including loans, similar to bonds they pay a steady income
International cooperation to prevent this from spreading like a disease
Government bailout and money printing (Quantitative Easing!)

Question 5

Probability theory

Answer 5

A crisis is a cumulation of a lot of little shocks that didn’t happen all at once. We want to think about the probability of those shocks occurring.

Question 6

What properties should stock prices have in “Efficient” markets?

Answer 6

Random, unpredictable
Prices should react quickly, correctly and fully to news
Investors cannot earn abnormal, risk-adjusted returns (or at least it shouldn’t be easy)

Question 6

Empirical properties of stock returns

Answer 6

What characterises stock returns
How volatile are stock returns?
Are returns predictable?
How does volatility change over time?
What types of stocks have the highest returns?

Question 7

Systematic risk

Answer 7

market risk, non-diversifiable risk

Question 8

Idiosyncratic risk

Answer 8

firm or asset specific, diversifiable risk