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FIN20040 - Foundations of Finance > Risk and Return > Flashcards

Flashcards in Risk and Return Deck (43)
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1
Q

Define Holding period return

A

Rate of return over given investment period. Its how much we get for each unit cash invested in security

2
Q

What are the two components of return

A

Income component is dividends and capital gains

HPR = Div Yield + Capital gains yield

3
Q

Define arithmetic average Return

A

Return earned in an average year over multiple years. What you earn in a typical year

4
Q

Define geometric average Return

A

Average compound Return each year over multiple years. What you actually earn. Assumes Y1 is reinvested

5
Q

Formula for geometric average return

A

[(1+R1) x (1+R2) x … x(I + Rt)]^1/t - 1

6
Q

Define risk free rate

A

Return earned with certainty - short term government debt securities usually used (short maturity)

7
Q

Define risk premium

A

Expected return in excess of that on risk free (reward)

8
Q

Define excess return

A

Additional return earned by moving from risk free investment to risky one

9
Q

What is the formula for expected return

A

Treasury bill(risk free) + risk premium

10
Q

What are the qualities of an efficient capital market

A

Security prices should reflect all available info and has competition - prices fluctuate with new info as investors reassess asset values based on that info

11
Q

What does the efficient market hypothesis state

A

Stock prices reflect all info. this means stock prices change unpredictably because information is unpredictable. - random walk

12
Q

What are some sources of information that might lead to stock prices changing?

A

Government figure on GDP
Drop in interest rates/ rise in sales
Result from latest arms control talks

13
Q

What is the formula for total return

A

R = E(R) + U where U is unexpected return

14
Q

Define delayed reaction on stock market

A

Suggests inefficent market - New information means prices partially adjust

15
Q

Define over reaction reaction on stock market

A

Suggests inefficent market - New information is overshooting price eventually correcting

16
Q

Name the three versions of efficient market hypothesis

A

Strong form EMH
Semi strong form EMH
Weak form EMH

17
Q

Explain the three versions of EMH

A

Strong form EMH - Stocks reflect all relevant info, even insider information
Semi strong form EMH - stocks reflect all public information already
Weak form EMH - Stocks reflect all information contained in history of trading - random component is due to new info

18
Q

Define technical analysis

A

Search for unpredictable patterns in stock prices

19
Q

Define fundamental analysis

A

Uses earnings, dividend prospects, expected interest rates, risk evaluation to determine the proper stock prices

20
Q

Define scenario analysis

A

Possible economic scenarios: specify liklihood HPR ex: examining recession and boom

21
Q

Define probability distribution

A

Possible outcomes with probabilities

22
Q

Define event study

A

Technique of empirical financial research enabling an observer to access the impact of an event on a firms stock price

23
Q

Define expected return

A

Return anticipates as return on a risky investment. Mean value of the distribution of realised returns - weighted average

24
Q

Define variance

A

Expected value of squared deviation from mean - average squared difference between actual return and average return

25
Q

Define portfolio

A

Group of assets held by investor

26
Q

Define portfolio weight

A

% of portfolio’s total value in a particular asset

27
Q

Define market risk/systematic risk

A

Risk attributable to market wide risk sources and remains even after extensive diversification is systematic risk or market risk

28
Q

Define non systematic risk

A

Diversifiable, firm specific risk can be eliminated

29
Q

What does the diversification principle mean

A

Means spreading an investment across assets (portfolios) eliminates some but not all of risk - some is systematic. Adding more stock to portfolios means deviation from expected return decreases too

30
Q

What does systematic risk principle tell us about return on an asset

A

Expected return on asset depends only on its systematic risk as the unsystematic risk can be eliminated at no cost - hence there is no reward for bearing it

31
Q

Define Beta coefficent

A

Measures sensitivity to market risk - amount of systematic risk in a risky asset relative to that in an average risky asset

32
Q

What is the difference between risk premium and excess return

A

risk premium- expected return

excess return - realised return

33
Q

If B<1 what does this mean

A

Stock has low volatility - defensive stock ex: coca cola

34
Q

If B>1 what does this mean

A

Stock has greater volatility to fluctuating returns - aggressive/cyclical stock ( bought more in boom and less in recession)

35
Q

If B=1 what does this mean

A

Market portfolio beta

36
Q

If B=0 what does this mean

A

Beta of risk free asset

37
Q

Define market risk premium

A

Difference between expected return on market and interest rate on the risk free asset

38
Q

formula for risk premium on an asset

A

E(Ri) - Rf

39
Q

In equilibrium what should reward to risk ratio be?

A

same for all assets

reward to risk for market = reward to risk for asset

40
Q

What is principle of risk to reward ratio in equilibrium called?

A

Capital pricing model

41
Q

Give the equation of the security market line and details of the graph

A

E(Ri) = Rf +[E(Rm)- Rf] x Bi - CAPM

Slope is market risk premium!

42
Q

What is the fundamental relationship between beta and expected return

A

assets must have same reward to risk ratio and must plot all on the same straight line

43
Q

If assets plot above/ below SML what does this mean?

A

Above - Unpriced (current price too low)

Below - Overpriced (current price too high)