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Flashcards in SG Deck (26)
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1
Q

Fisher Separation theorem

A

under certain conditions the shareholders can delegate to the management the task of choosing which projects to udetake, whereas they themselves determine the optimal financial decisions.
hence, the investment and financing choices can be completely disconnected from each other.
2 periods
2 types of investment: physical investment projects (POF) or financial (lend/borrow - CML)
The firm will first invest in all physical investment projects with returns greater than 1+r (until tangency point)
The decision of physical investment will be taken by all firms regardless of the preferences of their owners.

2
Q

Fisher separation assumptions

A

perfect capital markets - vital
borrowing and lending occur at the same rate
unrestricted amount of lending and borrowing
no transaction costs associated with the use of the cpital market

However, usually, fo example, borrowing rate is higher than lending. Then, probably, two tangential points, so agents would choose differing physical investment decisions.

3
Q

NPV

A

NPV of the project is just the sum of the present values of receipts, less the sum of the Pvs of the payments.
It is the optimal technique for corporate management to use if they wish to maximize expected shareholder wealth.
Performs well under all circumstances and should be employed.

4
Q

Payback period

A

payback period -> enough cash in the payback period to repay imitial investment?

Payback is flawed: portion of the CF stream is ignored in project evaluation. Payback ignores the time value of money. Can be eliminated by discounting project CFs that accrue within the payback period.

5
Q

IRR

A

IRR is compared to a hurdle rate (required rate of return).
Solution to a polynomial may not be unique
In the evaluation of mutually exclusive projects, use of the IRR rule may lead to choices that do not maximise expected shareholder welath.

6
Q

The multiples method

A

Market information can be used to estimate the value.
The method assesses the firm’s value based on the value of a comparable publically traded firm.
MV/Earnings ratio
MV/EBITDA
MV/CF
MV/BV

Should always be used in conjunction with other merhods like NPV.
It incorporates a lot of information in a simple way. It does not require ssumptions on the discount rate and growth rate. The weakness is the assumption that the comparable companies are truly similar to the company one is trying to evaluate. But we also assume market is always correct. This approach would leas to big mistakes if money making opportunities are present.

7
Q

Conglomerate discount

A

the estimate of the sum of individual parts is on average 12% greater than the traded value of the conglomerate.
It is possible that the conglomerate is a less efficient form of organisation due to inefficient capital markets.
It is possible that the multiples method used is inappropriate here because signle segment firms are too different from divisions of a conglomerate operating in the same industry.

8
Q

Diversification

A

It seems that by forming bundles of assets we can eliminate risk: through holding portfolios of assets, we can reduce the risk associated with our position.
THe correlations between assets are less than perfect. It implies that when returns on the first are above average, those on the second need not be above average. Hence, the returns will tend to cancel each other out, implying that the the cariance for a portfolio will be smaller than the corresponding weighted average of the indiviual asset variances.

The portfolio variance falls as the number of assets increases
The limiting portfolio return is the average covariance between assets returns.

9
Q

Indifference curves in MV analysis

A

steep for risk-averse

flat for less risk-averse

10
Q

two-fund separation

A

Any risk-averse investor can form their optimal portfolio by combining two mutual funds. The first of these is the tangency portfolio of risky assets, and the second is the risk-free asset. All that the degree of risk-aversion dictates is how much weight is placed on the funds.

11
Q

Assumptions for CAPM/mean-variance analysis

A

investors maximise their utility defined over expected return and return variance
unlimited amounts of borrowing and lending at Rf
Homogeneous expectations regarding future asset returns
Asset markets are perfect and frictionless (no taxes, no transaction costs, short selling allowed)

+ Equilibrium in the capital market: demand for risky assets identical to the supply => market portfolio = tangency portfolio

12
Q

Market portfolio

A

portfolio comprising all assets where the weights used un the construction of the portfolio are calculated as the market capitalisation of each asset divided by the sum of market capitalisation of each asset divided by the sum of market capitalisations across all assets.

13
Q

idiosyncratic risk

A

sigma^2 E

the risk is unrelated to market fluctuations and does not affect expected returns

14
Q

undiversifiable risk

A

beta^2 sigma^2 M
cannot be escaped and hence increases equilibrium expected returns
it is driven by variation in the return on the market as a whole

15
Q

Market efficiency

A

A market is said to be efficient with respect to some information set W if no agent can make positive economic profit through the use of a trading rule based on W. Economic profit is defined as the level of return after costs are adjusted appropriately for risk.

In other words, if I know some information, then I cannot exploit it and earn a positive net risk-adjusted return, if the market on the asset is efficient.

16
Q

Weak-form efficiency

A

if prices fully reflect historical information (past prices, financial characteristics of firms, macroeconomic indicators)

17
Q

Semi-strong-form efficiency

A

if prices fully and speedily reflect all new public information releases. And all past public information, too.

18
Q

Strong-form efficiency

A

if prices reflect all information, both public and private. More difficult to test.

19
Q

Joint hypothesis problem (testing market efficiency)

A

Empirical researchers do not know the true model that generates expected returns in the economy. Hence, the choice of expected return-generating mechanism may be just wrong. So, abnormal returns may be incorrectly measured.
We are in a position when we are not sure wheteher markets are inefficient or our model is wrong.
The null is comprised of two components:
1) informational efficiency
2) the accuracy of one’s model for expected returns

20
Q

weak-form efficiency implications and tests

A

the inability of current and past returns to forecast the level of future returns.
cov(Rt,Rt-s)=0
compute autocorrelations of returns!

test of return autocorrelation can be viewed as test of the random walk model (Pt=Pt-1+Et)
Other tests include whether the sign of returns is predictable.
Also, regressions like Rt+1=alpha+beta Xt +ut
testing beta=0
Looking for calendar effects (same regression with dummy for day/month)

21
Q

Calendar effect

A

pattern in stock returns related to either the day of the week, the week of the month or the month of the year.
Example: consistently higher returns on Wednesdays.
Could be tested Xt-dummy for calendar effect.

22
Q

Weak-form efficiency: empirical results

A

1) Tests of return autocorrelation
The results vary with the frequency over which the returns are calculated.
daily, weekly: positive autocorrelation. Fama (1965) and Lo and MacKinlay (1988).
Lo and MacKinlay also show that the strength of autocorrelation is dependent on the size of the stock in question (market cap.). Small stocks - higher autocorrelation. Due to infrequent and non-synchronous trading, maybe even when the returns themselves are uncorrelated. So, it is not obvious that the return predictability reflects informational efficiency.

long horizons: negative autocorrelation. Fama and French (1988) and Poterba and Summers (1988) returns over 3-5 years. Indication of informational inefficiency. However, it might be the case that such long swings in prices reflect mean reversion in expected returns over time, which is not picked up by the expected return-generating model (joint hypothesis problem).

2) Calendar effects
January effect: returns are statistically positive and greater in January than in any other month of the year. Most pronounced for small stocks. Explanations are taxation impacts, year-end effects, effect from remuneration packages of fund managers. Extremely puzzling continued existence of this effect (can be eliminated by rational traders).
day of the week effects: French (1980)
holiday effects: Haugen and Lakinshol (1988)

3) Impact of other variables on returns
Lakonishok, Shleifer and Vishny (1994): choosing shares whose price is low relative to fundamentals (earnings, dividents). The value portfolio outperforms the glamour one by 10-11% per annum over a preiod of 5 years.
DeBondt and Thaler (1985): allocate stocks to portfolios based on the past performance measured by excess returns. Losers are found to subsequently outperform winners by 25% over the 3 years.

By comparing the actual earnings growth rates with the expected earnings growth rates implicit in stock prices, the authours find that the high ecpected rate is only validated for 1-2 years. naive strategies of following the trend, overreacting.
Fama and French (1992) have a different interpretation. size and book-to-market capture the variation associated with the fundamentals. So, they think value stocks are fundametally riskier.
Again, joint hypothesis discussion

4) Technical Trading rule
Example: MA crossover
Brock, Lakonishok and LeBaron (1992) apply the rule with some success.
Levich and Thomas (1993) show available profits, too.

23
Q

Semi-strong form efficiency implications and tests

A

speed at which new info is incorporated into prices. Event study is the primary method for examining efficiency of this scope.
We would expect a picture of a high rise on the announcement date of the cumulative abnormal returns function.
Gradual increase in this function means information inefficiency.

24
Q

Semi-strong form efficiency: empirical evidence

A

Asquith and Mullins (1983) show that unexpected divident increases cause stock price rises. (often within 5-10 minutes of the announcement)

Ball and Brown (1968) report that stock prices do not fully incorporate the info of earnings announcements. Prices of good news stock continue to rise, while bad ones continue to fall.

25
Q

Strong-form efficiency implications and tests

A

corporate insiders make gains from trading in their own company’s stock?
forecasts of professionals and experts?
mutual fund performance?

26
Q

MM1 Assumptions

A

capital markets have no frictions (no taxes, no transaction costs)
investors have perfect information and homogeneous expectations
investors care only about their wealth
financing decisions do not affect investment outcomes - key!
another key - all cf is going only to debt or equity holders