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CMA2 > 5.2 Risk and Return > Flashcards

5.2 Risk and Return Flashcards

1
Q

Return ON Investment (ROI)

A

Return - (minus) Amount Invested

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2
Q

Rate of Return

A

Return on Investment/

Amount Invested

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3
Q

Two Basic Forms of Risk

A 
Systematic Risk (Market Risk): Risk faced by ALL firms.
  Economy, etc. It is UNDIVERSIFIABLE

Unsystematic Risk (Non-Market or Company (Specific) Risk) : Diversifiable through Portfolio diversification

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4
Q

Other Forms of Risk (not Systematic/Unsystematic)

PIF-C
PIF-L

A

Credit Risk: Risk ISSUER OF DEBT will default

Foreign Exchange Risk: Risk FX will be affected by Exchange Rates
Interest Rate Risk: Risk Investment will fluctuate in value due to interest rate change
Industry Risk: risk to INDUSTRY. Airlines due to fuel prices.
Political Risk: probability of Risk due to govt action. (Expropriation). Can be reduced by making foreign entity dependent on Domestic corp for Technology, etc.
Financial Risk: Risk based on markets (due to interest maybe)
Purchasing Power Risk: General increase in cost will reduce what can be bought for same dollars
Liquidity Risk: security can’t be sold on short notice for its market value

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5
Q

Risk Averse v Risk Neutral v Risk Seeking

A

Averse: Disutility of Loss exceeds Utility of Gain
Neutral: Disutility of Loss equals Gain
Seeking: Utility of Gain exceeds Disutility of Loss

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6
Q

List of Financial Instruments by Risk (Low to High)

T12S,

A 
T Bonds
First Mortgage Bonds
2nd Mortgage Bonds
Subordinated Debentures
Income Bonds
Preferred Stock
Convertible Preferred Stock
Common Stock
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7
Q

Indifference Curve

A

An investor curve that shows investment returns on X axis. Risk on Y axis. Different risk and returns are plotted. ON the same curve it doesn’t matter which is selected. Steeper the Curve, more risk averse.

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8
Q

Maturity Matching

A

Making sure securities will not have to be sold unexpectedly. Maturity of Funds coincides with the need for the funds.

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9
Q

Uncertain Cash Flows of an Investment=

Cash Flows Certain

A

Then need to consider Marketability and Market Risk

Certain = Maturity is most important

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10
Q

Hedging

A

Offsetting Commitments to minimize risk of adverse price movements

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11
Q

Natural Hedge

A

Buying different investments whose performance cancels each other (Insurance is a natural hedge)
Pair Trading: long and short positions
Sometimes: Stocks and Bonds

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12
Q

Futures Contracts

A
  • to hedge commodities
  • agreement to buy/sell commodities at a price in a later month
  • Can be bought/sold on margin (risky..leverage)
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13
Q

Expected Rate of Return

A

Sum of all probabilities by Weight

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14
Q

Standard Deviation (and risk)

A

The wider the standard deviation (variance) the great the risk

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15
Q

Security Risk (individual) v Portfolio Risk

A
  • Should evaluate Risk based on portfolio not individual stock
  • Risk is NOT average of the Standard Deviations of the stocks. because stocks are imperfectly correlated, combining stocks is LESS than the Average of the Standard Deviations.
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16
Q

Correlation Coefficient

A

Degree to which any TWO variables are correlated 1.0 to - 1.0.
- Perfect negative correlation = perfect hedges of each other (risk ELIMINATED)

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17
Q

Covariance

A

Covariance of a Two Stock Portfolio =

Correlation Coefficient x Std Deviation1 x Std Deviation2

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18
Q

Risk and Diversification (Diversifiable)

A

Specific Risk: (Divirsifiable, Unsystematic, Residual, Unique) regarding a company’s operations (new products, patents, competitor activities) can be reduced through DIVERSIFICATION

Diversification works 20-30 stocks and then benefits decline to near zero with 40 Stocks.

19
Q

Risk and Diversification (Market or Undivirsifiable or Systematic)

A

Risk of the STOCK MARKET as a whole. Things that affect ALL stocks like the NATIONAL ECONOMY

20
Q

BETA of an individual Stock

A

Effect of an individual stock on the VOLATILITY of a portfolio measured by it’s beta. 1.0 = perfectly positively correlated to MARKET portfolio. 20% market change = 20% Stock change. Less than 1.0 moves differently 20% Market and security 10% = .5 Beta

More than 1.0 means more volatile.

Can be calculated by

Variance of Return on Market

21
Q

Beta of PORTFOLIO

A

Wtd Average of Betas of INDIVIDUAL SECURITIES

22
Q

Factors on INDIVIDUAL stock’s Beta

A
  1. Debt To Equity (Financial Leverage)
  2. Operating Leverage (Fixed Costs to Variable Costs)
  3. Characteristics of the industry it operates
23
Q

CAPM (Capital Asset Pricing Model)

A

To measure the risk an individual Security contributes to the risk of Portfolio

Quantifies the Risk of a Security by relating the Risk to Average RETURN on the Market

Beta is applied to the Rm over Rf

Rs = Rf + B (Rm-Rf)

Rf = Time Value
RM - RF is the Market Risk Premium

Problems with CAPM

a. hard to estimate Rf in different Economic Conditions
b. CAPM is single period (don’t use over 1 year)

24
Q

Value at Risk (VaR)

A

Technique to determine Max Gain or Loss using a bell curve. Within a certain period, at a given level of confidence.

Highest point = most probable event

  1. 96 standard deviation = 95%
  2. 57 = 99%

Cash Flow At Risk and Earnings at Risk use the same principal

25
Q

Basis Points

A

300 Basis Points = 3%

26
Q

Spontaneous Financing

A
  • Trade Credit

- Accrued Expenses (Wages paid after employees Work)

27
Q

Annualized Cost of not taking a Discount

A

Discount % x Days in Year
————— ——————
1- Disc % total pmt period - Discount Period

28
Q

Term Loans and Lines of Credit

A

most used after spontaneous

  • increased risk of insolvency
  • risk that short term debt might not be renewed
  • contractual restriction such as Compensating Balance
29
Q

Effective Interest Rate

A

Usable Funds

or without dollar amounts

Interest Rate

  1. 0 - Stated Rate
30
Q

Prime Rate

A

Rate for best customers

31
Q

Simple Interest Loan

A

Interest paid at the end of the loan

Loan Amt x Stated Rate = Interest Expense

Effective Rate and Nominal Rate are the same

Interest Expense
____________
Usable Funds = effective AND nominal

32
Q

Discounted Loan

A

Interest is paid AT THE BEGINNING of the loan.
The USABLE FUNDS are Loan Amt - Interest (paid at beginning of loan)

Usable Funds

  1. 0- Int Rate ==== Loan Amt

1 -.08 = 97,286

EFFECTIVE RATE =

Net Interest Expense 7286
—————————— ————–
Usable Funds 90,000 = 8.696%

33
Q

Compensating Balance

A

Forced to keep a balance at bank

1 - Comp Balance % ……….Loan Amount =

Stated Rate
——————–
1 - Compensating Balance %&raquo_space;>Effective Rate

34
Q

Discounted Loan with Compensating Balance

A

Effective Rate =

                        Stated Rate --------------------------------------------------------- 1 - Stated Rate - Compensating Balance %
35
Q

Line of Credit with Commitment Fee

A

A line of credit, but there is a fee on the unused balance

Annual Cost =

Interest on Average Balance + Commitment Fee on Unused portion

(Avg Bal x Stated Rate) + (Credit Limit -Avg Bal) x committe fee % to get unused

36
Q

Banker’s Acceptances

A

short term financing
- A depositor puts money in the bank, bank accepts (guarantees) pmt to the holder of the draft of the face value or holder can sell it at a discount
_ Difference between face and proceeds received is interest expense

37
Q

Commercial Paper

A
  • short term unsecured Notes Payable in denominations of 100K
  • issued by large corps, pensions, banks
  • usually below Prime

Pros: Broad Distribution, Large amount of funds,
Avoids costly financing arranagements

Cons: Impersonal market, Limited by the excess liquidity of corporation

ANNUALIZED RATE =

Net proceeds x Number of Terms per yr

38
Q

Secured Financing

A
  • Pledging Receivables (eg)
  • Bank will lend on a percent of receivables

Trust Receipt: Inventory is collateral (Held in Trust by the bank) paid with proceeds of sale to the lender.

Chattel Mortgage: secured by Personal Property. (Equipment or Livestock)

Floating Lien: Also secured by inventory (the composition changes since it is not a specific item)

39
Q

Maturity Matching

A

Equalized the Asset acquired with the Debt used to finance

40
Q

Long Term Financing (Leases)

A

Leases; Right to Use for a stated period of time (for long lived assets without tying up large amts of capital

since it has interest expense, after tax cash outflows

Net Advantage to Leasing:
PV of Debt Financing v PV of Leasing

41
Q

Convertible Securities (why is it cheaper)

A

Cheaper than straight Common so cheaper cost of capital due to it’s enticement

42
Q

Warrants (Stock Purchase)

A

Used to Lower the cost of debt

- the right to by shares at a specified price

43
Q

Retained Earnings

A
  • Lowest cost of capital since no issuance costs

- The cumulative Accrual Income - Dividends

CMA2 (30 decks)

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