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Capital Assets > Capital Assets > Flashcards

Capital Assets Flashcards

1
Q

List the five basic components of the investment process

A

Investor Characteristics, Investment Vehicles, Strategy Development, Strategy Implementation and Strategy Monitoring

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2
Q

Investor Characteristics

A

Return requirements and risk tolerance along with any constraints

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3
Q

Investment Vehicles

A

Once characteristics have been established, opportunities can be explored

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4
Q

Strategy Development

A

The investor can start to optimize based on available investment opportunities

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5
Q

Strategy Implementation

A

Problems may arise due to transaction costs or not enough market liquidity

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6
Q

Strategy Monitoring

A

Investors must constantly monitor and revaluate their investment strategy as the market is ever changing

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7
Q

Why different investors adopt different investment strategies

A

Investors will adopt different strategies based on their risk and return preferences, a low risk investor may chose to invest in low risk assets such as treasury bonds where as those with higher risk tolerance may chase riskier assets in search of higher returns. Strategies will depend on the amount of cash flow that’s desired.

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8
Q

Why investors adopt different investment strategies

A
  1. Changing market conditions, 2. Investment goals change, 3. Risk Tolerance may change, 4. Portfolio Diversification, 5. Investment Experience
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9
Q

Divisibility in terms of physical and financial assets

A

Financial assets are usually highly divisible and will buy and sell at small denominations. Physical assets may vary, like real estate may be not be easily divisible but assets like gold can be sold at smaller units.

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10
Q

Marketability in financial and physical assets

A

Marketability refers to the ease an asset can be bought or sold. Financial assets have a generally high marketability as they can easily be bought and sold. Marketability will vary for physical assets, for example gold is highly marketable but real estate will depend on a range of factors.

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11
Q

Holding period in financial and physical assets

A

Holding period in terms of financial asset will depend on the type of investment, day trader may hold an investment for a matter of minutes but a long term investor may hold assets for years. Physical assets will also vary but in general have a longer holding period. Real estate may be longer where things like technology may be shorter.

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12
Q

Information availability in financial and physical assets

A

Financial assets will typically have more information since they are publicly traded and highly regulated. Physical assets will vary, assets such as gold or oil have a lot of information but assets such as real estate are limited.

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13
Q

‘The Ownership of the Firm is Residual in Nature’

A

Owners have a claim on the residual profits after all expenses have been payed. They are the last in line to receive payouts. This gives shareholders incentive to monitor the performance of the company.

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14
Q

Conversion ratio

A

= number of shares

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15
Q

Conversion price

A

= par value / conversion ratio

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16
Q

Conversion value

A

= value if the bond was converted in present time. number of shares x stock price

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17
Q

Interest Rate Risk

A

risk that investor may face due to changes in interest rate, determined by supply and demand for credit.

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18
Q

Equity Risk

A

potential loss due to fluctuations in the value of stocks/ equity investments, equity represents ownership of a company and is sensitive to the companies performance.

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19
Q

Default Risk

A

risk the borrower may not be able to pay back their debt obligations.

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20
Q

Commodity Risk

A

Prices in stock may change due to changes in commodity prices, such as oil, gas and metals. Will depend on the extent that a company relies on the commodities.

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21
Q

“Investing in mutual funds guarantees a profit”

A

No, investing in mutual funds does not guarantee profit. Mutual funds are subject to market risk and their returns are no guaranteed. The performance will depend on factors such as underlying securities, economic conditions, interest rates and global events. Although mutual funds are a popular investment due to potential high returns, compared to a savings account, they also come with risk. Proper risk assessment must be done before investing. Past performance is also not a guarantee that it will continue to be a high returning investment.

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22
Q

How to find the NPV.

A

( C / (1+r) ^ n - Initial Investment )

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23
Q

Future Value.

A

FV = PV x (1+r)^n

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24
Q

PMT formula (Automation)

A

PMT = PV x r / (1-(1+r)) ^-n

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25
Q

Is the rate of return the most important metric?

A

Where it is important it is not the most important. Different investors will favor different metrics depending on the investing goals. An investor might priorities capital preservation rather than profit maximization, which would indicate they would prefer risk measures to minimize risk.

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26
Q

Do investments need to be perfectly correlated?

A

The goal of diversification is to spread investments across different assets in order to minimize overall risk. The degree of correlation is to be considered. If securities have a low or negative correlation, risk may be reduced as assets will move in different directions. Diversification does not need to be negative in order to provide benefit. Correlation may be a bad thing since assets may start to mirror each other.

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27
Q

How do Sharpe Jensen and Treynor performance index differ

A

The Sharpe ratio is a measure of excess return per unit of risk, where risk is measured as the standard deviation of returns. It evaluates the performance of an investment relative to its risk level, and a higher Sharpe ratio indicates better risk-adjusted performance.

The Treynor ratio is similar to the Sharpe ratio but uses systematic risk (beta) instead of total risk. It measures the excess return per unit of systematic risk, where systematic risk is the risk of the investment that cannot be diversified away in a portfolio. A higher Treynor ratio indicates better risk-adjusted performance, given the level of systematic risk.

The Jensen performance index measures actual performance compared to expected performance. A positive jensen indicates the asset has performed better than expected, a negative jensen indicates it has under performed.

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28
Q

The Sharpe Performance Index

A

(Return-RFR)/STD, Sharpe index measures the return in relation to the risk free rate divided by the STD. The higher the Sharpe Ratio the better the risk adjusted performance.

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29
Q

The Treynor Performance Index

A

(Return-RFR)/Beta, Treynor Index measures the return in relation to beta. The main difference between the Treynor and Sharpe performance index is that Treynor measures for for systematic risk where the Sharpe ratio measures both systematic and unsystematic risk

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30
Q

The Jensen Performance Index

A

(Return-(RFR+(Return on Market-rfr)(Beta). The Jensen Performance Index measures the excess returns compared to expected returns. A positive Jensen indicates the portfolio has outperformed the market. Its main difference is that its comparing performance relative to returns rather than by systematic and unsystematic risk.

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31
Q

The Efficient Frontier

A

The efficient frontier represents a set of portfolios that offer the highest expected returns. The efficient frontier plots the expected returns against the risk measured by the STD. Risk and return can be optimized by combining different assets that are not perfectly correlated.

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32
Q

Can the mean-variance criterion identify the optimal investment

A

Mean variance is used to maximize return and minimize risk. Where it is use the optimal criterion depends on investment preferences. The MVC assumes that investors are risk averse and seeking to maximize profit which might not always be the case. Investors may be risk seeking or risk neutral.

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33
Q

beta

A

correlation(std/1)

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34
Q

Expected return in portfolio

A

weighted average of expected return

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35
Q

Variance in portfolio

A

Sum of weighted variance of assets plus twice the sum of weighted co variance between each pair of assets

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36
Q

Can individual risk be diversified away

A

Risk of an individual asset can be diversified away by combining them in a portfolio with other assets with differing risk.

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37
Q

Can co-variance be diversified away

A

Not completely, covariance refers to how assets move together, even well diversified portfolios can have a high co-variance.

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38
Q

Explain separation theorem of the CAPM

A

CAPM suggests investors can separate their investment decisions into two components, risk free and risky assets. Optimal portfolio can be found with a mix of both assets determined on risk preferences.

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39
Q

What is the beta measure of risk

A

Measures the systematic risk of the market as a whole eg beta 1 suggests the asset moves in line with the market

40
Q

SML

A

Graphic representation of CAPM, shows expected return and systematic risk, above the line suggests high returns

41
Q

Systematic Risk

A

Market risk as a whole, eg inflation, cannot be diversified away

42
Q

Unsystematic Risk

A

Effects specific company or industry, can be reduced by diversification in portfolio

43
Q

Describe techniques used for a firm to determine whether an asset is viable.

A

Future Value, NPV, Measuring risk using Sharpe, Treynor, Jenson models, CAPM model.

44
Q

Credit-migration Risk

A

Risk due to potential changes in credit worthiness of the borrower or the issuer

45
Q

Difference between life insurers and property causalities

A

Life insurers offer long term investment and provide long term investment eg life insurance, invest in long term stable growth assets.
Property Causalities protect against short term risk ie property damage. May have riskier investments and higher tolerance for volatility.

46
Q

What is the connection between the mean-variance criterion and the mean-variance efficient frontier?

A

The mean-variance efficiency criterion provides a quantitative way to evaluate the risk-return trade-off of different portfolios. The mean-variance efficient frontier illustrates the relationship between risk and return for a range of portfolios, helping investors to make informed decisions about how to allocate their assets.

47
Q

Is short selling riskier.

A

Yes, there is unlimited loss potential, if the stock rises you may need to up front more cash, time risk- stocks could keep going up indefinitely.

48
Q

Callable Bond

A

A protocol which allows firms to repurchase bonds prior to their maturity date

49
Q

Convertible Bond

A

Option to convert the bond into a fixed number of stocks

50
Q

Primary Market

A

Firms raise money through selling stocks, bonds and other securities and suppliers can sell part of their company to the public

51
Q

Secondary Market

A

Previously issued securities are traded between investors

52
Q

Operations in a Primary Security Market

A

An Initial Public Offering (IPO) is being offered to the primary market for the first time. Firms ‘going public’ are guided by the investment banks.

53
Q

Operations in a Secondary Security Market

A

Buying and selling of stocks where the seller is not the original issuer. Price is determined by supply and demand. Guided with the help of brokers.

54
Q

Institutionalization

A

Collecting of peoples savings and investing them into the financial market to make a long term profit ie pensions.

55
Q

Non Life Insurance / Property Causality Insurance

A

Provides insurance against things other than life, eg Private Health Care, Property Insurance

56
Q

Life Insurance

A

Where an individual pays an insurance company a premium so that upon their death their family gets lump sum payments or regular payment

57
Q

Investment Behavior of Life Insurers

A

They build a large pool of assets and invest them into long run financial assets (credit market and money market investments).

58
Q

Investment Behavior of Property Causality

A

Much shorter term investments, do not benefit as much from the law of large numbers.

59
Q

Pension Funds

A

An asset pool that accumulates over a workers employed years that benefits them in non-working years.

60
Q

Pensions - Defined Benefits

A

Benefits that are earned based on a formula

61
Q

Pensions- Defined Contribution Plans

A

Only specify how much is to be saved.

62
Q

Pensions- Defined Contribution Plans

A

Only specify how much is to be saved.

63
Q

Open end funds

A

Able to issue new shares on a daily basis

64
Q

Closed end funds

A

Are not able to issue new shares daily

65
Q

Hedge fund

A

an unregistered, privately offered,
managed pool of capital for wealthy, financially
sophisticated investors

66
Q

Preferred stock

A

represents ownership of the company but usually doesn’t have voting rights

67
Q

Mutual Funds

A

Mutual funds are investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other assets

68
Q

Closed end investment funds

A

An investment fund that issues a fixed number of shares.

69
Q

Corporation bonds

A

Investing money into a corporation for a fixed length of time.

70
Q

Treasuries

A

Debt obligations of the government

71
Q

Compare hedge funds to mutual and investment trusts

A

hedge funds are generally the most complex and risky, while mutual funds and investment trusts are more widely available and have more conservative investment strategies.

72
Q

What is the most widely accepted model explaining IPO under-pricing, and
what is this model’s main assumption

A

The most widely accepted model explaining IPO under-pricing is the “winner’s curse” model. The model’s main assumption is that the issuer does not know the true value of the firm and that potential buyers have better information about the value of the firm than the issuer. As a result, the issuer sets the IPO price below the true value to ensure that the issue will be fully subscribed, but this leads to under-pricing and the issuer leaves money on the table. The model assumes that there is asymmetric information between the issuer and the investors, and that the investors have an incentive to obtain shares at a price below the true value, which can result in the under-pricing of the IPO

73
Q

Why must open-end funds keep more cash on hand than closed-end funds

A

Open-end funds must keep more cash on hand than closed-end funds because they must be prepared to meet investor redemptions at any time. Closed-end funds issue a fixed number of shares through an initial public offering (IPO) and do not redeem shares directly from investors.

74
Q

Rate of Return

A

Measures profitability of financial asset. Measures the gain or loss over a certain percentage of time. When comparing profitability, absolute dollar bill is meaningless and percentages are more appropriate.

75
Q

One way to quantify risk is to measure the dispersion of returns around expected returns

A

variance or standard deviation

76
Q

If two assets are positively correlated

A

they move together in the market (win/ win, lose / lose)

77
Q

If two assets are negatively correlated

A

They offset eachother

78
Q

Why is diversification important

A

Diversification is important because it helps to reduce risk in an investment portfolio. By spreading your investments across different assets, such as stocks, bonds, and commodities, you reduce the impact of any single asset on the overall performance of your portfolio

79
Q

Asset covariance

A

The individual risk of assets can be diversified
away but the risk caused by asset covariances
cannot because covariance cannot be diversified away. Covariance cannot be diversified away because it represents the interdependence of an asset

80
Q

Minimizing Risk

A

-All risk can be diversified away when two assets are perfectly negatively correlated.
-Zero risk investment will always involve positive investment in both assets.

81
Q

Assumption for investors

A

Are risk averse and prefer a high return.

82
Q

Portfolio Possibility Curve

A

relation ship between return and risk

83
Q

Suppose you are interested in two stocks, A and B. The spot prices of A and B are 10 euro per share.
You anticipate the price of A to increase to 15 euro, but the price of B to decline to 5 euro. You have
1000 euro and plan to borrow 50 shares of B from a stockbroker. Explain your investment strategy
and calculate the expected return of your investment strategy.

A

Your investment strategy in this scenario would involve buying 100 shares of stock A at the current price of 10 euro per share, for a total investment of 1000 euro. You would also borrow 50 shares of stock B from the stockbroker, and sell them immediately at the current price of 10 euro per share, receiving 500 euro in return.

You would then wait for the anticipated price changes to occur. If the price of stock A increases to 15 euro per share as you anticipate, you would sell your 100 shares for a total of 1500 euro, earning a profit of 500 euro.

At the same time, if the price of stock B does indeed decline to 5 euro per share, you would use the 500 euro you received from selling the borrowed shares to buy back 100 shares of stock B at the lower price, returning them to the stockbroker and ending your borrowing arrangement. You would have spent 500 euro on buying back the borrowed shares, but received 500 euro when you sold them earlier, resulting in no net gain or loss.

Therefore, your expected return from this investment strategy would be 500 euro, which is the profit you make from selling stock A after buying it at 10 euro per share

84
Q

Concepts behind CAPM

A

-Equilibrium (investors hold optimal portfolio)
-Risk free assets (return is 1)
-Market Portfolio (Includes risky assets weighted at market value)
-Separation Principle (at equilibrium, investors regardless of risk preferences hold the market portfolio of risky assets)

85
Q

Capital Market Line

A

The Capital Market Line (CML) is a graphical representation of the relationship between risk and return of a portfolio that includes a risk-free asset and a risky portfolio. In contrast to the mean and std, applies to efficient portfolios.

86
Q

Security Market Line

A

Graphs returns of the CAPM model. Relationship between the mean and beta, applies to portfolios whether they’re efficient or not.

87
Q

Risk Free Asset

A

Guaranteed return without fear of losing the initial investment

88
Q

Equilibrium Rate of Return

A

Hypothetical rate of return in a perfect equilibrium market

89
Q

Market Portfolio

A

A theoretical portfolio that contains all assets and securities in the market.

90
Q

3 Properties of Market Portfolio

A

Includes all investable assets, it is value weighted (each asset is weighted using its market weight), its efficient (invested to get the highest returns).

91
Q

Separation theorem

A

the theorem suggests that an investor’s portfolio can be separated into two components: the risk-free asset (such as government bonds) and a diversified portfolio of risky assets (such as stocks)

92
Q

Why does the security market line (SML) describe the capital asset-pricing model (CAPM) equilibrium relationship between risk and expected rate of return

A

The SML shows the relationship between the expected return and the systematic risk (beta) of an asset. Assets that lie on or above the SML are considered to be adequately compensated for their risk, while assets that lie below the SML are overvalued and assets that lie above the SML are undervalued

93
Q

CAPM

A

R= rfr + beta (rm - rfr)

94
Q

FV (compound)

A

PV x (1+r/n) ^ (nxt)

95
Q

Discounting

A

(FV) 1/1+r^n

96
Q

Limiting assumptions of CAPM

A

Assumes rfr (return without any risk), equilibrium market (no transaction costs), assumes risk and return prefrences.

97
Q

Short selling

A

short selling is where investors borrow shares of a stock and sell them at market price to hopefully buy them back for a decreased price.

Capital Assets (1 decks)

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