Test 1 Flashcards
(104 cards)
1
Q
What are the key elements in an “investment”
A
- Resources (money, human capital, social capital like networking)
- Goals, such as return
- Willingness to take risks
- in this case, we are talking more broadly about what constitutes an investment, not just financial
- e.g. education, health care, housing, retirement, insurance etc.
2
Q
What is the difference between expected return and realized return? Why is there a difference?
A
- Expected return refers to the best ESTIMATE of what will happen in the FUTURE time horizon (think of a distribution of possible returns, where the “mean” is the expected return)
- two ways to calculate E(r): 1) Forward Looking, 2) Historical
- Realized Return refers to ACTUAL return
- The differences comes from RISK (macro/systematic risk and firm/idiosyncratic risk) –> recall factor model!
3
Q
AM versus GM
A
- GM is always SMALLER than AM
- If stock price goes from 100 to 110 back to 100, GM will be 0% , whereas AM will be a positive value (average of 10% and - 9%)
- GM is a better indicator for PAST Performance, as GM considers ACTUAL starting capital accumulated
= (1 + r)(1 + r)(1+r) - AM is a better indicator for FUTURE performance, as AM assumes starting capital is 1 in every period
(just takes the average of individual returns for each period)
> AM assumes times series of historical returns represents the TRUE underlying probability distribution
4
Q
Why do we need skewness and kurtosis?
What is skewness and kurtosis, specifically with signs?
With signs of skew over and estimate risk?
A
When stock returns are NOT normally distributed, we use kurtosis and skewness to better determine risk
For a return distribution:
Skew can be + or - and refer to the “symmetry”
- is there a left or right pull on the tail?
- Positive skew -> the standard deviation OVERESTIMATES risk, because extreme positive surprises increase estimate of volatility
- Negative skew -> the standard deviation underestimate risk
r(s) = HPR
Kurtosis refers to “peakedness” and “flatness” and can also be + or -
- Leptokurtic = Positive kurtosis = high peaks and fat tails = Normal distribution has Kurt = 3
> greater likelihood of extreme values on either side of the mean at the expense of lower likelihood of moderate deviations
- Mesokurtic = Zero Kurtosis
- Platykurtic = Negative kurtosis = flat peaks and thin tails
- when describing the implications of kurtosis and skewness, remember to COMPARE tails and values to the normal distribution
e. g. negative skew means more negative values than normal distribution, positive kurtosis means steeper peakedness than normal distribution
5
Q
What can we invest in?
A
Real Assets
- Land, buildings, machines, knowledge, human capital
- real assets generate “net income” in the economy
- determine the “production capacity”
Financial Assets
- Short term Investments: money market instruments (T-bills, CDs, CPs, BAs)
- Long term Investments: stocks (common, preferred, indices), bonds (treasury, corporate, municipal, international), derivatives (options, futures)
- give individuals a “claim” to income generated by real assets
- indirectly contributes to productive capacity by permitting individuals to invest in the government and firms, which increases productive capacity
Direct or Indirect Investment (via investment companies)
6
Q
What is indirect investment?
What are the services provided?
What are the costs of investing in a mutual fund?
What are the returns of a mutual fund?
A
- investment companies that “pool funds” from many individual investors to invest in a wide range of financial assets
- e.g. Mutual funds, REITs, Hedge Funds
- services provided include: administration and record keeping, DIVERSIFICATION, professional management, reduced transaction costs
Mechanism:
- Investors BUY SHARES in investment companies
- value of each share = Net Asset value = (MV of assets - Liabilities Owed) / shares outstanding
Costs of investing in a mutual fund:
- Operating Expenses = “expense ratio” = % charged to manage mutual fund
> deducted from returns
- Front-end load = upfront “sales charge” or commission when you purchase shares = reduces capital invested
- Back-end load = redemption or exit “sales charge” when you sell your shares within a specified period of time, typically DECREASES every year the funds are left invested
- 12 b-1 charge (in the US) = ANNUAL marketing and distribution fee
> like operating expenses, deducted from returns
> add 12-b1 charge to operating expenses to get true annual expense ratio
**the choice is usually between paying a one-time “load” or the annual 12-b1 fees, which depends on your investment horizon
> if you plan to hold for a long time: opt to pay one-time load than annual fees
Mutual fund returns:
> change in NAV plus income and capital gain distributions
> NAV can capture expense ratio
e.g. NAV1 = NAV0( 1 + return - expense ratio)
7
Q
Where can we invest in?
A
Financial Markets!
1) Primary Financial Market - firms ISSUE new securities
- firms use this to RAISE capital
- e.g. IPO, SEO
2) Secondary Financial Market - investors trade previously issued securities among themselves
- firms do not get capital
Benefits of Secondary Financial Markets:
1) Serve as an “indicator” of a country’s economic condition => changes in the economy are REFLECTED in stock prices
2) Help drive prices of financial assets towards their intrinsic value => economic efficiency
3) Contribute to economic growth through more efficient allocation of resources for funds (via investment and divestment)
4) Provide employment opportunities - brokers, stock dealers, investment bankers
5) Improve corporate governance by making firms be subject to scrutiny by a large variety of shareholders
6) Provide liquidity to investors due to the presence of a large number of buyers and sellers
7) Enable investors with idle money to earn some returns (capital appreciation or dividends)
8) provide a safe, legal and convenient way to trade securities since they are regulated to prevent scams, frauds
8
Q
Functions of Financial mproddddarkets
A
Financial markets…
1) Provide information (stock prices reflect firm’s current performance and future prospects)
2) Allow for timing of CONSUMPTION (shift consumption over time)
3) Allocation of Risk according to investor’s risk tolerance
4) Separation of Ownership and Management
5) Corporate Governance
6) Corporate Ethics via the Sarbanes Oxley Act => requires more independent directors, limits the role of auditors/prohibits them from selling other services to their clients
9
Q
Explicit versus Implicit Costs of “Trading”
A
Explicit = broker commission
- pay broker for services such as, executing orders, holding securities for safe keeping, extending MARGIN LOANS, faciliting short sales, providing informatiion and investment advice
- full service versus discount brokers
Implicit = Dealer’s Bid-Ask spread
- bid is lower than ask
- Bid = max price BUYER is willing to pay –> received by investor is selling
- Ask = min price SELLER is accept –> paid by the investor if buying
- why? Bid-Ask spread is PROFIT for the DEALER for making the market
10
Q
Trading On margins
- what is it
- what does margin mean
- why would investors buy on margin?
- what does initial margin mean
- what does maintenanec margin mean
- what does margin call mean
- rate of return?
- how do we deal with interest charge?
A
Investors who purchase securities have the option of accessing “debt financing” called BROKER CALL LOANS or Margin Loans = “Buying on Margin”
- Investor BORROWS PART of the security purchase price from a broker
- Margin = Equity = portion of the purchase price contributed by the investor, expressed as a %
Margin = Equity / Value of Stock
- the remainder is liability = BORROWED from the broker (the broker then borrows from a bank and charges interest + service charge to investor)
- interest is treated as liability
Why?
Allows investors to invest a greater amount than their money allows
- with greater upside potential comes greater risk too
Initial Margin (e.g. 50%) = starting contribution from the investor (e.g. investor must pay at least 50% of the security’s price in cash)
Maintenance Margin = minimum amount in the margin account (equity) which will SIGNAL a MARGIN CALL
Margin Call = investor must top up their margin account up to Initial Margin by adding new cash or securities (e.g. 60% of new stock value)
- if investor does not top up, the broker will start SELLING securities from the account to pay off loan and restore to appropriate margin level
Rate of Return = Percent Change in Equity
Interest charge is treated as additional liability that decreases your margin and equity:
> don’t forget about COMPOUNDING interest
> e.g. monthly interest rate
loan(1 + mthly interest rate)^# of months
11
Q
Short Selling
- what is it
- purpose?
- mechanism (overview)
- Explain assets, liabilities, and equities for short selling
- Profit
- how do you deal with dividends?
A
Sell security then buy it
Purpose is to profit from a DECLINE in the security price
Mechanism:
1. Investor BORROWS shares from a broker
2. Investor SELLS shares
3. Later, Investor BUYS shares and returns to broker
(hopefully buy shares at a lower price than what was sold)
*Short Seller must also pay the broker/lender of the security ANY DIVIDENDS that were paid
Participants:
- owner of shares (broker’s client)
- broker
- short seller
Short sellers also need to have a margin account with the broker to cover LOSSES should the PRICE RISE
Assets, Liabilities and Equities:
1) Assets represent what’s in the investor’s ACCOUNT with the broker
- Sales Proceeds from short sale get deposited into the account (Cash)
- Initial Margin in your account to be able to execute short sale (cash or securities)
2) Liabilities = the value of the borrowed shares = if you bought shares now, how much would it cost to close your position and return the stock?
3) Equity = Assets - Liabilities
Margin (%) = Equity / Value of Stock (NOT including Initial margin in your account)
Profit = change in share price * # of shares shorted = change in Equity
Dividends?
> the original shareholder A in which the broker borrowed the shares from to lend to the short sellers is entitled to dividends
> however, now shareholder B is the official owner of the shares who will receive dividends
> therefore, the short seller must pay shareholder A the dividends from HIS OWN POCKET
12
Q
What are the four steps to Asset Allocation
A
- Assess RISK TOLERANCE => utility
- Estimate Portfolio RISK and RETURN => formulas
- identify OPPORTUNITY SET => graphs, tangency port
- Optional Asset Allocation => imposing utility curve, finding the optimal complete portfolio
* detailed steps are subject to the scenario (all risky assets, 1 risky 1 rf etc.)
13
Q
What are the assumptions for risk preference?
A
- investors prefer MORE wealth to less wealth
- investors prefer LESS risk to more risk => investors are NOT risk neutral!!
- experience MORE DISUTILITY from a DECLINE in wealth than from an equal increase in wealth
- Marginal benefits = derive less satisfaction with each incremental wealth
- prefer a CERTAIN outcome to an uncertain outcome of equal value (for risk free asset versus risky asset of same return)
14
Q
What is A?
How does A impact the Indifference curve?
A
degree of risk aversion
A < 0 –> Risk loving –> flatter curve
A = 0 –> Risk Neutral
A > 0 –> Risk Averse –> STEEPER curve (need greater E(r) to compensate for increase in port risk)
Indifference curve:
X axis = stdev
Y axis = expected return
Left up most corner = highest utility
*Choose Portfolios that give you the HIGHEST UTILITY
15
Q
Can indifference curves cross?
A
For a single individual, NO
16
Q
How to you create an indifference curve?
A
Indifference curve represents combinations of E(r) and SD at the same utility
1) Find Utility givenrisk free rate (where SD = 0)
- -> utility = rf (intercept)
2) At this utility, use A and change SD to find the corresponding E(r)
17
Q
what are the values that p must be between?
A
-1 and 1
Two assets with p = -1 refers to perfectly negative correlation => jagged triangle
=> MVP has a SD = 0
**special case!!
Two assets with p = 1 refers to perfect correlation => straight line between two assets
18
Q
What is diversification?
A
> well diversified portfolios do not have any idiosyncratic risk
> they only have market risk/systematic risk
> diversification REDUCES variability of returns WITHOUT an equivalent reduction in expected return
> to diversify, you must invest in several DIFFERENT asset CLASSES (equities, bonds) and sectors, which will make the correlation coefficient among these assets less than 1
19
Q
What is the capital allocation line?
A
Line that represents the opportunity set of a portfolio consisting of the risk free asset and a risky asset
20
Q
What is the efficient frontier?
A
efficient frontier represents the opportunity set comprised of combinations of risky assets above the minimum variance portfolio
The actual curve itself is constructed by graphing the “Minimum Variance Frontier”
=> plotting the lowest variance attained for a given portfolio expected return (solver)
21
Q
What is the minimum variance portfolio (MVP)?
A
MVP is the portfolio comprised of risky assets that has the lowest SD
22
Q
What is the tangency portfolio?
A
The tangency portfolio is the RISKY portfolio that gives the HIGHEST Sharpe Ratio
It is also known as the “Optimal Risky portfolio”
(the next step would be to find the optimal complete portfolio, which allocates between Optimal Risky portfolio and risk free asset)
23
Q
Draw the optimal complete portfolio for:
A. 1 rf + 1 risky
B. 2 risky
D. Many risky + 1 rf
A
see notes
24
Q
Markowitz Port. Selection Model
What is it?
A
A theory on how to create and construct a PORTFOLIO of assets to MAXIMIZE returns within a given level of risk
> wanted to eliminate idiosyncratic risk
All investors, regardless of their risk preference, will AGREE on the SAME RISKY portfolio (M) and by extension, have the same CAL
Key Conditions/Assumptions:
> all investors have the SAME perception regarding the probability distribution of risky securities => homogenous expectations
> can borrow and lend at the SAME rate (rf)
25
Two fund separation theorem (separation property)
1) All investors, regardless of their risk aversion, will invest in the SAME RISKY Portfolio
> the determination of the risky portfolio is purely technical
2) Capital allocation of the "complete portfolio" between t-bill and risky portfolio depends on personal preference (aka movement along the CAL)
26
What is the CML?
Capital markets line is a special type of Capital Allocation Line that only applies to an ECONOMY where EVERYBODY is looking at ONE SINGLE OPTIMAL RISKY PORTFOLIO
Only applies to 2 benchmark securities: 1) Market Portfolio, and 2) risk free security
> CML does not apply to individual securities or any portfolio
27
Opportunity set with leverage
What is the sign of the weights for borrowing?
+ weight = investing (long)
| - weight = borrowing (short)
28
Opportunity set with leverage
Differential borrowing and lending rates > what does the CAL look like?
Usually borrow at a higher rate in order to compensate for potential DEFAULT risk
> kinked CAL
> kink occurs at 100% risky asset
29
Capital asset pricing model
Assumptions
one of the 3 Asset pricing models that relates risk to return
> Motivation: to know how financial markets PRICE securities and thereby determine the equilibrium RELATIONSHIP between risk and expected return.
> CAPM works for all individual securities AND portfolios
> CAPM implies that the "excess returns" or "risk premiums" of ALL assets (individual assets and portfolios) are proportional to Beta
As an equilibrium model, CAPM requires these assumptions to be held to make the model work!
Individual Behavior:
1. Security markets are very competitive and EFFICIENT
> markets capture all available info
2. Markets are dominated by RATIONAL, mean-variance optimizers
> investors prefer more wealth, demand a premium for risks they assume, are risk averse
3. investors have a COMMON INVESTMENT HORIZON
Other assumptions that can be relaxed to modify CAPM:
Market Structure
4. Investments are limited to TRADABLE ASSETS
5. investor may borrow and lend at rf rate
6. NO market frictions like taxes and transaction costs
7. People have homogenous expectations (about future probability distribution of returns)
30
CAPM, Portfolios, individual assets, and rewarding risk
***In the CAPM world, all investors hold the MARKET PORTFOLIO in different proportions with the risk free asset (recall markowitz portfolio theory and the CML)
What exactly is the market portfolio?
= sum of market values of each stock (P*# of shares outstanding)
> All (publicly traded) assets have to be included in the market portfolio.
Individual assets exist in this economy have some RELATIONSHIP with the market portfolio
> Covariance between A and market portfolio
> Beta
*In the CAPM world, investors are REWARDED for RISK that is CORRELATED with the Market Portfolio, NOT total risk (unlike Factor model)
> CAPM does not imply that investors need higher return to hold more "volatile stock", but rather, to hold stocks with higher covariance with the market
31
Applications of CAPM
1. Simplifies Asset Allocation
> CAPM reduces the # of inputs needed for asset allocation exercise (no need for matrices)
> How? CAPM does NOT consider COVARIANCE BETWEEN assets, only covariance with the market portfolio
2. Identifying Positive Alpha stock ("mispriced securities")
> individual securities that do not fall on the SML are considered mispriced
> Lie ABOVE SML => Undervalued (gives you higher exp return for a given amount of risk) => BUY
> Lie BELOW SML => Overvalued (gives you less exp return for a given amount of risk) => Sell
> Alpha = Abnormal return = difference in expected return and CAPM "implied" return
> want positive alpha (not negative alpha)
* in competitive markets, though, security prices will drive back to SML
32
Questions related to which of the following scenarios are possible in a CAPM world
1. given Expected returns and betas of 2 portfolios
2. given Expected returns and SD of 2 portfolios
3. given market, risk free rate, and portfolio A's expected return and beta
4. given market, risk free rate, and Portfolio A's expected return and SD
1. set up CAPM equation and solve for rf and rm
> is rf less than rm?
2. Set slopes of SML equal to each other, subtitute formulas to find the RATIO of correlation coefficients of each portfolio with the market
> Subbing in 10% for rf, is correlation coefficient between A and B between -1 and 1?
3. Calculate expected return of A according to CAPM and compare with stated expected return of A
> are there any discrepancies?
4. Set slopes of SML equal to each other, substitute formulas to get correlation coefficient for A with the market
> Is the correlation coefficient between -1 and 1
33
Does CAPM work in reality?
> not easy to find a proxy for the market portfolio in reality
> CAPM is untestable, so it is impossible to reject CAPM
> Empirical tests of CAPM have suggested that returns are POSITIVELY related to beta and UNRELATED to unsystematic risk => CAPM still works
34
Factor model
What is it?
Realized return?
> it is a statistical model that can be testable
> begins with the assumption that the SOURCE OF RISK originates from "MACRO FACTORS"
> returns are all EXCESS return
Realized return = Expected Return + Differences from Surprises
= Expected Return + [Macro risk + Firm Risk]
= E(r) + Bi,1*(R1 - E(R1) + Bi,2*(R2 - E(R2) + ...+ ei
35
What is alpha in single factor model?
Alpha represent abnormal return, or the "EXPECTED excess return" = E(Ri)!!
> explains the connection between the two Ri formulas in my formula sheet :)
> in factor model, it is the y intercept after running a linear regression of factor models
> regression:
X axis = Market excess return
Y axis = Security excess return (P1/Po - 1 - rf)
> Statistical significance using t statistics reveals whether alpha is statistically different than 0
> economic significance is the magnitude of alpha
If alpha IS SIGNIFICANTLY different than 0:
> alpha is used for SECURITY SELECTION if underlying return is a single security
> alpha is used for ARBITRAGE trading strategies if underlying return is portfolio return
36
What is beta in Factor model?
Beta represents the "slope" of the linear regression
> we also care about economic and statistical significance
> Beta represents "exposure" to that source of risk
> also known as "sensitivity" to that source of risk
37
What does adjusted R squared mean in Factor model?
How well does the real data fit the one-factor model
> how well diversified is the portfolio?
> high R squared = pretty well diversified, low idiosyncratic risk
1 - R^2 = idiosyncratic risk
38
What is risk under the normal distribution?
Standard deviation
39
What is normal distribution and its properties?
The normal distribution is a CONTINUOUS, BELL-SHAPED Distribution set by 2 parameters: its mean and standard deviation
> symmetrical around the mean, so that mean = median = mode
> 68% of values fall within +/- 1 standard deviation from the mean
> 95% of values fall within +/- 2 standard deviations from the mean
> 99% of values fall within +/- 3 standard deviations from the mean
40
Stylized findings in terms of tradeoff (stocks versus bonds)
Asset classes that provide GREATER RETURN are MORE RISKY
> stock returns are higher than bond returns
> stock standard deviations are higher than bond standard deviations
> rankings also hold in global markets
41
Define risk premium
the extra reward (return) for bearing the RISK of investing in equities rather than in bills or bonds.
Also it's the extra reward to compensate investors for taking on risk associated with the excess return
This is why Sharpe Ratio is a measure of EXCESS returns
> risk is measured by the SD of excess returns
42
Why are shorting stocks considered risky?
> there is a general UPWARD Trend in stock prices, which hurts profits from short sales
> over time, stocks APPRECIATE as INFLATION erodes away the value of currencies
> to protect against inflation, companies pass on extra costs to customers
43
Firms/households/governments/intermediaries
Are they net savers or net borrowers?
Firms: Net borrowers (often RAISE capital to fuel growth)
Households: Net savers (e.g. retirement, RESP, purchase securities by firms)
Governments: Generally BOTH, however, the US is Net Borrower (huge budget deficit) and Singapore is Net Saver (huge budget surplus)
Intermediaries: Pool and invest funds
> Financial intermediaries bring suppliers of capital TOGETHER with demanders of capital
44
Single Factor Model
Single Factor Model (market portfolio is a factor):
Ri = E(Ri) + Bi*M + ei
where:
> Ri = Excess Return = ri - rf
> Rm = rm - rf
> ei = idiosyncratic risk = firm risk = "RESIDUAL"
>when you tak expectation of the above, recall that E(ei) = 0, so
E(Ri) = alphai + betai*(E(Rm))
Therefore, "Expected" Excess Return for Security i
= E(Ri) = alphai + Bi*E(Rm) + ei
where alpha and beta are constants, and Rm changes every period
Note: when the security i is correctly priced by the market, then the abnormal return, alpha, is expected to be ZERO for security i.)
Therefore, "Realized" Excess Return for Security i
= Ri = E(Ri) + Bi*(Rm - E(Rm)) + ei
= E(Ri) + Bi*Surprise of market + Surprise of security i
*For portfolios, you use the same formulas except you change "i" with "p", and ei is close to 0
45
Multiple Factor Model
How does it work?
Multiple "Risk Factors"
Ri = alphai + Bi,1*Factor1 + Bi,2*Factor 2 + ei
Bi,1 is the beta connecting security i to factor 1
F = risk premium = E(r) - rf
To find the Total Return o the portfolio (Ri) = SUM [ Bi*Fi ] + risk free rate
= total risk premium + rf
= (Ri - rf) + rf
= Ri
* Verdict: The Factor Model does NOT do well for Individual Stocks (only CAPM works). Therefore, MULTI-FACTOR model APPLIES to PORTFOLIOS
* *We don't use factor model for single securities, since securities are subject to huge idiosyncratic risk
How does it work:
> run portfolio EXCESS return against multiple factors
> outcome:
Coefficient of these factors = Factor Beta = determines whether there is POSITIVE, NEGATIVE, or ZERO "exposure" to that particular factor
(magnitude and sign of beta)
46
Multiple Factor Model:
| Chen, Roll, Ross 5 factors
Paints a broad picture of the macro-economy:
1. Industry Production
2. Unanticipated inflation
3. Unanticipated change of risk premiums*
4. Twists in Yield curve
5. Changes in expected inflation
47
Multiple Factor Model:
| Fama-French 5 factors
1. Market Factor (MKT RF)
2. SMB = Small Minus Big
> RETURN of a portfolio of SMALL stocks minus the RETURN of a portfolio of LARGE stocks
3. HML = High Minus Low
> RETURN of a portfolio of stocks with HIGH BOOK TO MARKET (value stock) minus the RETURN of a portfolio of stocks with LOW BOOK TO MARKET ratio (growth stock)
4. RMW = Robus Minus Weak (profitability factor)
> RETURN of a diversified portfolio with ROBUST PROFITABILITY minus RETURN of a diversified portfolio with WEAK PROFITABILITY
5. CMA = Conservative Minus Aggressive
> RETURN of a diversified portfolio of stocks with LOW INVESTMENT minus RETURN of a diversified portfolio of stocks with HIGH INVESTMENT
48
Investors expect the market rate of return in the coming year to be 12%
The risk free rate is 4%
Company A's stock has a beta = 0.5
Market value of its equity = $100M
Assume that CAPM holds
Q: Suppose that Company A just won a lawsuit and is being rewarded $5M (this is the only surprise of the firm in the year).
Stock A earns a return of 10% and market return turns out to be 10%.
What is the EXPECTED gain from this lawsuit?
```
E(rm) = 12%
rf = 4%
BetaA = 0.5
```
Realized return, Ra = 10%
Realized return, Rm = 10%
1. Therefore, since we now KNOW Rm, we RERUN CAPM to get new E(rA):
E(rA) = rf + Ba*( rm - rf)
= 0.04 + 0.5*(0.1 - 0.04)
= 7%
2. Realized Return = Expected Return + Surprises
Therefore, Company A's surprises as a %
= Realized Return - Expected Return
= 10% - 7%
= 3% surprise
3. Expected Gain = Realized Gain - Surprises
= $5M - 3% * 100M
= $2M expected gain
therefore, we can use differences in realized and expected return to find "surprise" as a % of market value!
49
Arbitrage Pricing Theory
3 components
2 methods to solve
*First, identify whether an arbitrage opportunity exists > is there a mispricing?
> ratio of risk premium to beta (with respect to a macro factor)
> statistically significant positive alpha
1. Zero Risk (risk free)
> sum of your trades should give you a portfolio beta = 0
2. Zero Investment
> short one portfolio, long another portfolio, such that weights = 0
> SIMULTANEOUS trades
3. Profit from MISPRICINGS
Method 1:
1) Create portfolio Q using two given portfolios that give you same beta as the last portfolio
> find the weights and expected return
2) Based on the difference in expected return from port Q and old port, buy and sell each portfolio in equal amounts
3) Profit = difference in expected returns
Alternative method:
> find the weights of the two given portfolios that yield 0 beta
> based on the signs, short and buy the portfolios
> profit = expected return of the zero beta portfolio
= weight*E(ra) + weight*E(rb)
50
Why is Arbitrage a very powerful pricing tool?
> arbitrage is a mechanism to RESTORE the market and its prices back to EQUILIBRIUM
> in Efficient Markets, any profitable arbitrage opportunities will QUICKLY DISAPPEAR, since ALL INVESTORS (regardless of wealth or risk aversion) will try to take the arbitrage position
> thus, in equilibrium, there should be 0 arbitrage opportunities
> hence, mispricings will be eliminated
51
Arbitrage Pricing Theory versus CAPM?
1. # of investors needed
> APT only needs a few investors to quickly restore the market to equilibrium (since each one takes on a large position)
> CAPM needs many small investors to restore CAPM equilibrium or market efficiency (shifting portfolios by a small amount)
2. Market Portfolio
> APT does not need to use the true market portfolio to serve as the benchmark portfolio when finding the expected return to beta relationship
> CAPM requires the "unobservable" market portfolio
> thus, APT is more flexible: any well diversified portfolio lying on the SML can be the benchmark
3. Individual stocks or Portfolios
> APT only applies to portfolios
> CAPM applies to both portfolios and individual securities
52
What are the "maximum fees" each fund can charge to their clients?
Fund manager can only charge us the difference between Expected Return implied by CAPM and expected return using probability distribution, if the difference is POSTIVE
> if the Fund is performing worse than CAPM (e.g. give us lower return than CAPM) = no fee can be charged (the fund should be giving us money...)
> If the fund is performing better than CAPM (e.g. give us a higher return than CAPM) = fee equals difference
53
What is the purpose of asset pricing models?
Asset pricing models provide INPUTS for risk and return to be used for the Markowitz Portfolio Theory
54
Efficient Market Hypothesis
Definition
Types
Efficient Market Hypothesis states that the current security prices REFLECT ALL relevant and available information
> security prices follow a random walk, in which they change rapidly and randomly as new information arrives randomly (random walk hypothesis)
>> random walk with a POSITIVE DRIFT
>New information must be unpredictable; if it could be predicted, then the prediction would already be part of TODAY'S information. Thus stock prices that change in response to new information also must move unpredictably.
> the expected return based on the security's price is CONSISTENT with its risk (in line with Markowitz portfolio theory)
(you should have "positive expected return" due to adjustment for risk, just no excess profits)
> as such, alpha should be 0
There are 3 forms of efficient markets according to information type (NOT speed):
1. Weak form efficient
> security prices reflect all security-market historical information, such as price and volume data
> if markets are weak form efficient, past data has NO PREDICTION on future rates of return => you cannot devise a trading strategy based on past price movements to earn abnormal return
> prices already reflect new information (e.g. a buy signal already made the stock price increase)
2. Semi-Strong form efficient
> security prices reflect all public information (e.g. earnings, dividends, financial statements, P/E ratios, Book to market ratio), which include market and non-market information (quality of management, data on product lines)
> if markets are semi-strong form efficient, decisions made on "new, public information" should not lead to above average risk adjusted returns
3. Strong form efficient
> security prices reflect all public and private information
55
EMH: What is the joint hypothesis?
Joint Hypothesis: Market is efficient and Asset Pricing Model are truly correct
> the joint hypothesis problem is that testing for market efficiency is difficult or nearly impossible (2 unknowns, 1 equation)
> any test for market efficiency requires asset pricing models to find risk adjusted returns, which may or may not be accurate themselves
56
EMH: What are some reasons that explain above average risk adjusted returns?
1. Market is inefficient
2. Asset pricing model is incorrect
3. Measurement error (e.g. testing a forward looking model with historical data)
4. luck
5. Data snooping in which there is an ERROR with statistics or data manipulation ("torture the data until it speaks")
6. unrealizable profits due to transaction costs
57
Tests for Weak Form Efficiency
| assuming Asset pricing models are correct
1. Autocorrelation - testing for positive or negative "serial" correlations or patterns
> If there are serial correlations, then the market is NOT weak form efficient
2. Trading rule tests
3. Testing momentum and contrarian strategies
> two strategies that rely on PAST BEHAVIOR to provide potential abnormal returns in the future
> Momentum Strategy: invest in "winning stocks" comprised of PAST WINNERS
> Contrarian Strategy: invest in PAST LOSERS and sell past winners (aka investing against crowd behavior)
> if there are outperformance, then the market is NOT weak-form efficient
> it PAYS to spend time to find winning securities
58
Tests for Semi Strong Form Efficiency
| assuming Asset pricing models are correct
1. Event Studies - assessing the impact of an event or new information on security prices
e.g. Is there post earnings announcement drift (PEAD)?
> if there is a drift, then the market is NOT semi-strong form efficient (which is found in empirical evidence)
2. Return Prediction Studies - attempt to predict future returns using public information (like ratios)
> P/E Ratio: portfolios with LOW P/E stocks (aka value stocks) give you HIGHER risk adjusted returns
> Book to Market Value Ratio: portfolios with HIGH B/M (value stocks) perform better than low B/M firms on a risk adjusted basis
> Small firm effect: portfolios with small stocks perform etter than large stocks by 4.3% annually on a risk-adjusted basis, mainly in January
59
Tests for Strong Form Efficiency
| assuming Asset pricing models are correct
Do groups with private information earn abnormal returns?
There is CONSISTENT evidence that the market is NOT strong form efficient, as corporate INSIDERS can trade profitably
60
EMH Implications for Investment
1. Is the market weak form efficient?
> Yes: you cannot trade profitably based on historical information
> No: info is not instantaneous, so past stock price movements carry valuable information => perform Technical Analysis (look at patterns from historical prices and volume, such as moving averages, market timing)
2. Is the market semi-strong form efficient?
> Yes: you cannot trade profitably based on public information
> No: info is not instantaneous => perform Fundamental Analysis / Security Analysis (find undervalued stocks), and other strategies (neglected firms, January effect, Calendar effect)
61
What is technical analysis
Are there any issues with technical analysis?
Useful when the market is not weak form efficient (sluggish response to information)
> involves searching for "recurrent" and "predictable patterns" in stock prices
Earn profit from investments by:
1. Recording past price movements and patterns in pictures
2. Deducing future price movements from these patterns
* there is no consideration of economy, industry or company (as seen in fundamental analysis)
Examples of trends:
> LT, intermediate, and minor trends
> use "support and resistance lines" (which are price levels above or below which prices are unlikely to rise or fall > stuck in middle of these lines)
> MOVING AVERAGE
Buy signal: if price crosses MA from below (P is rising)
Sell signal: if price crosses MA from above (P is falling)
> Market Timing:
When the market goes up, you want to be "IN" the market
When the market goes down, you want to be "out" the market
Issues:
> bid-ask spread from frequent trading
> it is also difficult to time the market and your trades correctly
> successful/profitable rules lose power once popularized (rules themselves are reflected in the stock prices) > self-destruction of those trading rules
> this goes against even the weakest form of EMH
62
Investment under violation of semi-strong form EMH strategies
1. Neglected Firms and Trading Activity
> firms who have been "neglected" by analysts (i.e. smaller and lesser known firms) are those that are LESS LIQUID (have lower trading volume)
> these neglected firms tend to generate HIGHER ABNORMAL RETURNS
> confirms small firm effect
2. January Effect and other calendar effects
> returns in January seem to be higher than returns in Nov and Dec (perhaps due to the holidays)
> returns on Monday in Janaury tend to be LOWER than returns on other days of the week (perhaps due to reacting to information on Monday)
> market returns DECLINE the most near market closing time
63
Behavioral Finance
What is behavioral finance
Define information processing limits
Define behavioral biases
*(update definitions individually after you finish reading chapter)
Behavioral finance provides an explanation for ANOMALIES/Abnormal patterns by focusing on the fact that investors are NOT always rational and have their own BIASES
Information processing limits refer to the fact that people have a limited ability to process information...
(infer incorrect % distributions about future rate of returns - misestimate true probabilities of events and associated rates of returns)
```
Information processing limits include:
> forecasting errors
> sample size neglect
> overconfidence
> conservatism
```
```
Behavioral biases (tendency to make suboptimal decisions based on how they frame risk-return trade-offs) include:
> framing
> mental accounting
> regret avoidance
> prospect theory
```
64
Behavioral Finance:
What is under and over-reaction?
Because of behavioral biases, investors end up buying HIGH and selling low
* thus, it is helpful to use limit orders
65
Behavioral Finance:
What is prospect theory (which is associated with loss aversion)
Prospect theory (graph) describes how there is a DIFFERENCE in utility among losses and gains
> since individuals DISLIKE losses MORE than equivalent gains, they are more willing to TAKE RISKS to avoid a loss
> a loss of $1 gives you a larger change in utility than a gain of $1
> hence, the value function is not symmetric in utility (S shape)
>The certainty effect says individuals prefer certain outcomes over probable ones, while the isolation effect says individuals cancel out similar information when making a decision.
66
Behavioral Finance:
What is overconfidence
In finance, overconfidence is when an investor tends to OVERESTIMATE his knowledge, UNDERESTIMATE risks, and EXAGGERATES ability to control the situation
e.g. the dominance of active management despite underperformance
67
Behavioral Finance:
What is inertia/inattention
Inertia refers to the propensity for people to stick to the "status quo" (preference for things to remain the SAME and not change behavior)
e.g. choosing the default choice
Inattention refers to situations where people AVOID INFORMATION that is freely available, often to prevent the negative consequences of knowing such information
e.g. investors are less likely to check their portfolio online when the stock market is down than when it is up
> long term negative consequences include poor decision making
68
Behavioral Finance:
What are forecasting errors
when too much weight is placed on RECENT experiences.
| memory bias
69
Behavioral Finance:
What is sample size neglect and representation
Sample Size Neglect, which refers to when investors inaccurately assume that small samples are representative of populations on a larger scale.
> may extrapolate trends too far into the future
70
Behavioral Finance:
What is conservatism
a mental process in which people cling to their PRIOR or ORIGINAL views or forecasts at the expense of acknowledging new information
> people are TOO SLOW or TOO CONSERVATIVE to updating their beliefs in response to new information
e.g. underreact to new news such that prices gradually reflect information
71
Behavioral Finance:
What is framing bias
a person will process the same information differently depending on how it is PRESENTED and RECEIVED
72
Behavioral Finance:
What is mental accounting
Mental accounting is a fallacy when investors treat money differently depending on their sources
(segregate certain decisions)
e.g. risky portfolio using bonus money, safe portfolio using salary contribution
> When this happens, the risk and reward of projects undertaken are NOT considered as an overall portfolio and the effect of one on another is ignored.
73
Behavioral Finance:
Limits to Arbitrage
In Efficient Markets, mispricings and inefficiencies would ordinarily be eliminated because of arbitragers
However, Behavioral advocates argue that in practice, several factors LIMIT the opportunity to profitably conduct arbitrage, which may result in prices remaining MIS-ALIGNED (due to behavioral biases) for protracted periods of time
(actions of such arbitrageurs are limited and therefore insufficient to force prices to match intrinsic value.)
These factors include...
1. Fundamental risk associated with arbitrage, which results in a widening of the mispricing before the price converges to intrinsic value
> e.g. the market underpricing (which would entice a buy signal) could get WORSE (fall more) before it gets better
2. Implementation costs could LIMIT the ability of arbitrage activity to force prices to fair value
> e.g. when attempting to profit from an overpricing (by short selling), there are limits such as returning stock on notice, other fund limits
3. Model risk, such as trying to pursue unrealizable profit based on a faulty model to value the security
4. Noise Trader Risk, or the risk of a LOSS on an investment due to noise traders who make decisions based on EMOTIONS like fear or greed rather than fundamental changes to a security
74
Investment Strategy from Behavioral Finance:
| Fusion investing
Fusion investing involves INTEGRATING 1) fundamental valuation with 2) investor SENTIMENT
How it works:
> In periods where investor sentiment is MUTED, noise traders are largely INACTIVE => market returns are dominated by fundamental valuation
> in periods where investor sentiment is STRONG, noise traders are largely ACTIVE => market returns are impacted by INVESTOR SENTIMENT
E.g. Gangman style - related company benefited from the release of the song
75
What are the applications for EMH?
1. Implications for asset allocations.
2. Implications for active and passive investment.
> if you believe markets are efficient = passive strategy
> if you believe markets are not efficient = active strategy
3. To better understand how, why and when market is inefficient rather than yes or no.
4. Implications for performance measurement.
76
What are the applications for EMH?
1. Implications for asset allocations.
2. Implications for active and passive investment.
> if you believe markets are efficient = passive strategy
> if you believe markets are not efficient = active strategy
3. To better understand how, why and when market is inefficient rather than yes or no.
4. Implications for performance measurement.
77
CAPM implied return versus expected return more generally:
> CAPM assumes investors apply identical input lists to Markowitz - therefore, everyone has the same efficient frontier and CML
(homogenous expectations)
> In reality, we depart here from the simple CAPM world in that some investors now apply their own unique analysis to derive an “input list” that may differ from their competitors’
78
What are two main investment styles?
Characteristics and Objectives
Assumptions
Applications
```
1. Passive Strategy
> Assumes the market is EFFICIENT
> long-term, buy and hold strategy
> Objective: follow the BENCHMARK index (pure indexing methods) and MINIMIZE tracking error (x4 measures...)
> Low cost
> but, less exciting
> Less turnover
```
```
2. Active Strategy
> Assumes the market is INEFFICIENT
> Objective: OUTPERFORM on a risk-adjusted returns
> Higher cost
> More lucrative
> More turnover
> e.g. Hedge funds
```
79
How do you perform pure indexing?
| pure indexing methods
For Fund Managers or Institutional investors:
1. Full Replication
> buy ALL securities in the INDEX in the SAME PROPORTION to their weights in the index
> while this is costly, there tends to be the lowest tracking error
2. Sampling
> buy a REPRESENTATIVE SAMPLE of stock in the benchmark index
> while this is low cost, there tends to be a higher tracking error
For Individual Investors:
3. Hold Index Mutual Fund
> great for small investors
> the Index Mutual Fund REPLICATES the index
> more cost effective
> however, no interday trading or short selling
4. Hold Exchange Traded Funds (ETFs)
> tradable during the day
> lower costs too
> but need to pay a brokerage commision
80
What is the full spectrum of portfolio management, from least active to most active strategy?
1. Pure Indexing
2. "Enhanced" indexing
> target return = 1% over index
3. Constrained Active Management
> target return = 2-4% over index
4. Unconstrained Active Management
> target return 4% or more over index
5. Hedge Funds
> target returns are unrelated to the index
> typical benchmark is t-bill or LIBOR
81
What are the four tracking errors for passive investment?
FOR ALL OF THESE, you need to run a REGRESSION:
X axis = Benchmark Index's excess returns
Y axis = Fund's excess returns
1. R squared
= (explained variance)/(total variance)
*higher R^2 closed to 1, the better
2. Beta
= slope of regression line
*beta closest to 1, the better
3. With Sign Tracking Error
= SUM of differences between fund returns and benchmark returns
= Rpt - Rbt
* recall that error = difference from the benchmark
* later on, we care about the standard deviation of the tracking error for Information ratio
* want errors to be close to 0
4. Without Sign Tracking Error
= SUM of the Absolute Differences between fund returns and benchmark returns
* want errors to be close to 0
82
Risk-Adjusted Performance Measures for Active Management
specifically, IR should be between what bounds? what is the median IR?
ADJUSTED FOR TOTAL RISK:
1. Sharpe Ratio
> higher SR, the better
2. M square (%)
> create a hypothetical portfolio p* (comprises of p and rf asset) that has the SAME SD as the market portfolio
> you would first find the WEIGHTS of P*, then find expected return of p*
> difference in return = M square measure
> alternatively, M square = (difference in Sharpe Ratio)*SD market
ADJUSTED FOR SYSTEMATIC RISK:
3. Jensen's Alpha
= Average Portfolio return - CAPM Implied Expected Return
= abnormal return above or below CAPM
* if the manager's performance is due to LUCK, alpha should be statistically insignificant from 0
4. Treynor's Measure
> slope of SML
> if slope of SML is greater than slope of market = greater excess return per unit of systematic risk = BUY (overperformance)
> if slope of SML is smaller than slope of market = SELL (underperformance)
ADJUSTED FOR UNSYSTEMATIC RISK:
5. Information Ratio
= Jensen's alpha / unsystematic risk
where unsystematic risk = SD of residual
- 1 <= IR <= 1
* Good managers typically have IR of between 0.5 and 1
* Median is IR = 0
83
Do Treynor Measure and Sharpe Ratio give the same portfolio rankings?
If the portfolio is fully diversified => Yes
> this is because there is 0 unsystematic risk
If the portfolio is NOT fully diversified => No
> this is because SD captures unsystematic risk, whereas Beta does not
84
Active Fund's manager skill versus breath
Skill = Information Coefficient = correlation of forecast and realized residual returns = ability to pick up abnormal returns
Breath = # of independent bets per year (frequency of trading upon strategy)
85
Applications of Performance measures 1
Based on your investment objective, which measure do you use ?
The right way to evaluate a portfolio depends in large part on how the portfolio fits into the investor’s overall wealth...
1. If the portfolio represents your ENTIRE risky investment
=> performance measures adjusted for total risk = Sharpe Ratio
(compare portfolio's sharpe ratio against benchmark's sharpe ratio)
2. If the portfolio is one of MANY that will be ADDED to your existing, WELL DIVERSIFIED fund
=> performance measures adjusted for systematic risk (since there is NO idiosyncratic risk) = Jensen's Alpha and Treynor's Measure
> we care about the additional systematic risk this investment will contribute
3. If you seek an ACTIVE portfolio in ADDITION to an INDEX portfolio (e.g. hedge fund)
=> INFORMATION RATIO
> by holding an additional active portfolio, you are departing away from efficient diversification and assuming firm-specific risk in search for positive alpha
86
Applications of Performance measures 2
Performance measurement for hedge funds
Hedge funds seek ABNORMAL return, which is captured by the INFORMATION RATIO
> look at the IMPROVEMENT in the Sharpe Ratio
Sharpe Ratio of Optimally constructed "risky" portfolio
= Sharpe Ratio of Index Port. + Information Ratio in Active Portfolio
(all terms are squared)
87
Applications of Performance measures 3
Performance measurement with changing portfolio composition
> risk adjustment techniques ASSUME that the portfolio risk is CONSTANT over the relevant period
> however, when the portfolio CHANGES as a result of changes to investment STRATEGY or fund managers, there will be more drastic changes to MEAN RETURN and RISK
> this would give the appearance of HIGHER VOLATILITY (active strategy appears RISKIER than it really is)
> We conclude that for actively managed portfolios it is helpful to keep track of portfolio composition and changes in portfolio mean and risk
> therefore, calculate average return and SD for each period before a change
> you cannot use the same measures to capture the change = this would be inaccurate
88
Applications of Performance measures 4
```
Performance measurement of "style analysis"
> what do "styles" refer to
> examples of "styles"
> why do we do style analysis?
> what did Sharpe find?
> what was Sharpe's method?
```
Styles refer to INVESTMENT PHILOSOPHIES of managers
```
Examples include:
> small cap
> medium cap
> large cap
> High P/E (growth)
> Medium P/E
> Low P/E (value)
```
Style analysis means IDENTIFYING a money manager's overall investment philosophy.
> which stocks are PREDOMINANTELY HELD?
> Style analysis uses a multiple regression model where the factors are category (style) portfolios such as bills, bonds, and stocks.
Sharpe found that:
> 91.5% of the VARIATION in RETURNS of 82 mutual funds could be EXPLAINED by the funds’ ASSET ALLOCATION (or STYLE ALLOCATION) to bills, bonds, and stocks
> Later studies that considered asset allocation across a broader range of asset classes found that as much as 97% of fund returns can be explained by asset allocation alone
> the remainder of return variability is attributable to either security selection or market timing (by periodic changes in asset class weights)
Sharpe's method:
> Regress fund EXCESS returns against excess returns of INDEXES representing a range of asset classes
> The regression coefficient (R squared) on EACH INDEX would then measure the fund’s implicit ALLOCATION to that “STYLE.” (or RISK EXPOSURE to style port)
> Analyze coefficients of Beta
e.g. Beta for High P/E is 0.803, meaning that 80.3% exposure to high P/E or growth stocks
89
What are some issues with performance measures?
1. Need a large number of observations/historical returns (over long period of time)
2. Benchmark error
> the benchmark for passive strategy must be a good proxy for the market and mean-variance efficient
3. could have SHIFTING PARAMETERS like changing fund managers that make accurate performance evaluation difficult (e.g. exaggerates volatility)
90
What makes a good and relevant benchmark?
1. representative of investors' preferences (opportunities and objectives)
2. pre-specified and unambiguous
> everything must be announced before the investment gets taken place
3. have obtainable and attainable alternatives (for index)
> It is good to offer some alternatives, as people may QUESTION your selection of the benchmark --> convince stakeholders like the investors
91
What's the difference between Security Selection/Analysis and Asset Allocation?
> Asset allocation determines the MIX of asset classes to hold in a PORTFOLIO for an optimal risk-return balance based on the investor's risk preferences
e.g. Portfolio Theory
> while security selection is the process of identifying individual securities WITHIN a certain asset class that will make up the portfolio
92
Security Analysis (Fundamental Analysis or Fundamental Security Analysis)
What is it
Purpose
Assumption
Rationale
Fundamental analysis is the analysis of the determinants of VALUE, such as earnings prospects
The purpose of fundamental analysis is to identify stocks that are MISPRICED relative to some measure of “TRUE” VALUE that can be derived from observable financial data.
Assumption:
> security analysis exists because of the VIOLATION of SEMI-STRONG form EMH
> therefore, it is worthwhile to use ECONOMIC and ACCOUNTING information (earnings and dividends) to PREDICT stock prices, as well as search for MISPRICED SECURITIES
Rationale:
> each company's stock has an "intrinsic" or "fundamental VALUE" based on HOW MUCH the firm will GENERATE for investors in the FUTURE
> expressed as Vo
> equal to the Present Value of all Future Cash Payments to the investor (including dividends and capital gains)
> future dividends and cash flows
> belief is that stock prices will GRAVITATE towards their intrinsic value in the long term
> in the short term, there can be deviations between the market price and intrinsic value of a stock due to market irrationality ==> fundamental analysis
93
Security Analysis (Fundamental Analysis or Fundamental Security Analysis)
What are the 3 Steps (plus details)? Why do we need to these analyses?
Top-down approach
Why?
> our goal is to determine a firm's INTRINSIC VALUE (such as earnings prospects)
> Because the PROSPECTS of the firm are TIED to those of the broader economy, fundamental analysis must consider the business environment in which the firm operates.
> What factors are relevant to a firm's performance?
1. Macroeconomic Analysis
1.1. Global Economy
> economic growth and performance impacts stock market returns (forecasted GDP Growth, not historical)
> political risk (political issues and decisions have economic consequences, such as trade policy, protectionism)
=> Two factors: Government stability (measured by changes in political leaders) and Bureaucratic Quality (measured by structures in place to implement changes)
> Exchange Risk (fluctuations impact the dollar value of goods priced in foreign currency e.g. more or less expensive to purchase)
1.2 Domestic Economy
> there is a strong relationship between stock market returns and the domestic economy => the stock market tends to LEAD the economy in both peaks and troughs
> to predict stock market performance, we should use leading indicators that tend to rise or fall BEFORE the rest of the ECONOMY (e.g. stock prices, index of consumer EXPECTATIONS or sentiments for business conditions, yield curve slope, money supply average weekly hours of production)
> Concurrent or Coincident indicators include: industrial production
> Lagging indicators include: avg. duration of unemployment, changes in CPI for services
Other things to consider:
> Demand and supply shocks
> Fiscal policy (demand): government’s spending and tax actions
> Monetary policy (demand): manipulation of the money supply and interest rates (increase in supply reduces interest rates, which stimulate investment demand)
> Incentives and marginal tax rates (Supply - incentivize workers to produce goods and invest)
> Business Cycle (trough, expansion/recovery, peak, contraction)
2. Industry Analysis
> Sensitivity of earnings to the business cycle is dependent on:
1. Sensitivity of sales (e.g. discretionary versus staple goods)
> Cyclical (e.g. durables like capital goods, luxury) and defensive industries (e.g. food, utilities, pharmacy) = sensitivity to business cycle (determines outperformance at different stages of the business cycle)
=> cyclical industries tend to have high beta stocks!
2. Operating Leverage (firms with high FC are more sensitive to changes in business conditions).
3. Financial Leverage (use of borrowing)
> Sector Rotation (shifting portfolio across different industries that are expected to outperform according to the business cycle)
e.g. If pessimistic about the economy = shift into noncyclical industries
If optimistic = shift into more cyclical industries
> Industry Life cycle stages (do you prefer high growth but lots of competition, or low growth but little competition)
1. Start up
2. Consolidation
3. Maturity
4. Relative Decline
> Industry Structure and Performance: Porter's 5 Forces
1. threat of entry from new competitors
2. rivalry between existing competitors
3. price pressure from substitute products
4. bargaining power of buyers
5. bargaining power of suppliers
*issue with market timing changes in the economy!
3. Company-level Analysis
> valuation methods to uncover mispriced securities
> Dividend Discount Model
> Constant Growth DDM
> Multi-stage DDM:
Dividends in the early high-growth period are forecast and their combined present value is calculated. Then, once the firm is projected to settle down to a steady-growth phase, the constant-growth DDM is applied to value the remaining stream of dividends
> Relative Valuation Ratios
94
Security Analysis (Fundamental Analysis or Fundamental Security Analysis)
```
Company analysis:
> what is market capitalization rate (k)
> dividend yield?
> Holding period return and DDM
> what is ROE?
```
Market Capitalization Rate is the market's consensus value of the required rate of return as determined by CAPM
Dividend Yield = Dividend per share / CURRENT Price per share
= D1/Po
HPR = Dividend Yield + Capital Gains Yield
= D1/Po + (P1 - P2)/Po
= D1/Po + g
ROE is the cost of equity and represents the expected rate of return from investments
> when ROE is greater than k, reinvestment makes sense and will result in high (positive) PVGO and higher stock price
> however, if ROE is less than k and earnings are reinvested, PVGO will be negative
95
When is the constant growth dividend discount model valid?
k must be greater than g
> this is because if g exceeds k, the growth rate would be UNSUSTAINABLE in the long run
> Solution = use multi-stage DDM
96
In DDM, do stock prices grow at the same rate as dividends?
Yes (in the case of constant growth of dividends)
P1 = D2/(k - g)
= [ D1*(1+g) ] / (k - g)
= D1/(k - g) * (1+g)
= Po*(1+g)
97
Total asset turnover formula?
| Financial Leverage formula?
Total Asset Turnover = sales/total assets
Financial Leverage = Total Assets/Equity
98
When dividends are cut, stock price usually falls. Does this contradict our analysis that lower dividends (and higher retention of earnings) result in higher stock price?
No
> drops in stock prices are related to the NEW INFORMATION that accompanies dividend cuts
> if companies can convince investors that the dividend cut is a good thing, stock price will increase
> Similarly, if the information of a dividend cut is already expected, stock price won't budge
99
Try Assignment 2 New > Homework Assignment 6 > Q10, Q14, Q20
f
100
Relative Valuations Ratios
General Formula
Examples
Price = Price per QTY (on a PER SHARE BASIS) * QTY per Share
P/BV × BV per share (book value)
> how aggressively the market VALUES the firm
P/CF × CF per share (cash flow)
> better precision than earnings
P/Sales × Sales per share
> useful for startups with no earnings
> also the most stable
P/E × E per share
* keep in mind these are all PER SHARE
101
Relative Valuations Ratios
Price to Earnings and its relationship with ROE, plowback ratio
Trailing P/E
Leading P/E
> As ROE increases, P/E increases (high ROE gives good opportunities of growth)
> higher plowback ratio, P/E increases (more earnings is reinvested into the company) => only if ROE exceeds k
Trailing P/E = Po / Eo
Leading P/E = Po / E1 (includes growth)
102
. An analyst estimates the single index model for a portfolio using regression analysis.
He uses the portfolio total return as the dependent variable and the market return as the
independent variable. The intercept of the regression equation is 1% and β is 1.2. The riskfree rate of return is 2%. What is the alpha of the portfolio?
alpha = 1.4%
103
What is regret avoidance?
individuals who make decisions that turn out badly have MORE regret (blame themselves more) when that decision was more UNCONVENTIONAL
e.g. losing investment in an unknown startup, smaller firms
104
Applications of Performance measures 5
Market Timing
Market timing involves SHIFTING funds between a MARKET-index portfolio and a SAFE asset, depending on whether the market index is expected to outperform the safe asset
Regression is modified (with a square excess return term): excess returns of portfolio P and excess returns of the Market, M =>
rP - rf = a + b(rM - rf) + c(rM - rf)^2 + eP
> graph has an upward sloping curve
> a = alpha, b = beta, c = timing dummy variable
> If c turns out to be POSITIVE , we have evidence of timing ability, because this last term will make the characteristic line steeper as rM - rf is larger.
> this is because the investor will shift MORE into the market when the market is about to go up.
