Capital Assets Flashcards
List the five basic components of the investment process
Investor Characteristics, Investment Vehicles, Strategy Development, Strategy Implementation and Strategy Monitoring
Investor Characteristics
Return requirements and risk tolerance along with any constraints
Investment Vehicles
Once characteristics have been established, opportunities can be explored
Strategy Development
The investor can start to optimize based on available investment opportunities
Strategy Implementation
Problems may arise due to transaction costs or not enough market liquidity
Strategy Monitoring
Investors must constantly monitor and revaluate their investment strategy as the market is ever changing
Why different investors adopt different investment strategies
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.
Why investors adopt different investment strategies
- Changing market conditions, 2. Investment goals change, 3. Risk Tolerance may change, 4. Portfolio Diversification, 5. Investment Experience
Divisibility in terms of physical and financial assets
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.
Marketability in financial and physical assets
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.
Holding period in financial and physical assets
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.
Information availability in financial and physical assets
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.
‘The Ownership of the Firm is Residual in Nature’
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.
Conversion ratio
= number of shares
Conversion price
= par value / conversion ratio
Conversion value
= value if the bond was converted in present time. number of shares x stock price
Interest Rate Risk
risk that investor may face due to changes in interest rate, determined by supply and demand for credit.
Equity Risk
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.
Default Risk
risk the borrower may not be able to pay back their debt obligations.
Commodity Risk
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.
“Investing in mutual funds guarantees a profit”
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.
How to find the NPV.
( C / (1+r) ^ n - Initial Investment )
Future Value.
FV = PV x (1+r)^n
PMT formula (Automation)
PMT = PV x r / (1-(1+r)) ^-n
Is the rate of return the most important metric?
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.
Do investments need to be perfectly correlated?
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.
How do Sharpe Jensen and Treynor performance index differ
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.
The Sharpe Performance Index
(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.
The Treynor Performance Index
(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
The Jensen Performance Index
(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.
The Efficient Frontier
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.
Can the mean-variance criterion identify the optimal investment
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.
beta
correlation(std/1)
Expected return in portfolio
weighted average of expected return
Variance in portfolio
Sum of weighted variance of assets plus twice the sum of weighted co variance between each pair of assets
Can individual risk be diversified away
Risk of an individual asset can be diversified away by combining them in a portfolio with other assets with differing risk.
Can co-variance be diversified away
Not completely, covariance refers to how assets move together, even well diversified portfolios can have a high co-variance.
Explain separation theorem of the CAPM
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.
What is the beta measure of risk
Measures the systematic risk of the market as a whole eg beta 1 suggests the asset moves in line with the market
SML
Graphic representation of CAPM, shows expected return and systematic risk, above the line suggests high returns
Systematic Risk
Market risk as a whole, eg inflation, cannot be diversified away
Unsystematic Risk
Effects specific company or industry, can be reduced by diversification in portfolio
Describe techniques used for a firm to determine whether an asset is viable.
Future Value, NPV, Measuring risk using Sharpe, Treynor, Jenson models, CAPM model.
Credit-migration Risk
Risk due to potential changes in credit worthiness of the borrower or the issuer
Difference between life insurers and property causalities
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.
What is the connection between the mean-variance criterion and the mean-variance efficient frontier?
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.
Is short selling riskier.
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.
Callable Bond
A protocol which allows firms to repurchase bonds prior to their maturity date
Convertible Bond
Option to convert the bond into a fixed number of stocks
Primary Market
Firms raise money through selling stocks, bonds and other securities and suppliers can sell part of their company to the public
Secondary Market
Previously issued securities are traded between investors
Operations in a Primary Security Market
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.
Operations in a Secondary Security Market
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.
Institutionalization
Collecting of peoples savings and investing them into the financial market to make a long term profit ie pensions.
Non Life Insurance / Property Causality Insurance
Provides insurance against things other than life, eg Private Health Care, Property Insurance
Life Insurance
Where an individual pays an insurance company a premium so that upon their death their family gets lump sum payments or regular payment
Investment Behavior of Life Insurers
They build a large pool of assets and invest them into long run financial assets (credit market and money market investments).
Investment Behavior of Property Causality
Much shorter term investments, do not benefit as much from the law of large numbers.
Pension Funds
An asset pool that accumulates over a workers employed years that benefits them in non-working years.
Pensions - Defined Benefits
Benefits that are earned based on a formula
Pensions- Defined Contribution Plans
Only specify how much is to be saved.
Pensions- Defined Contribution Plans
Only specify how much is to be saved.
Open end funds
Able to issue new shares on a daily basis
Closed end funds
Are not able to issue new shares daily
Hedge fund
an unregistered, privately offered,
managed pool of capital for wealthy, financially
sophisticated investors
Preferred stock
represents ownership of the company but usually doesn’t have voting rights
Mutual Funds
Mutual funds are investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other assets
Closed end investment funds
An investment fund that issues a fixed number of shares.
Corporation bonds
Investing money into a corporation for a fixed length of time.
Treasuries
Debt obligations of the government
Compare hedge funds to mutual and investment trusts
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.
What is the most widely accepted model explaining IPO under-pricing, and
what is this model’s main assumption
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
Why must open-end funds keep more cash on hand than closed-end funds
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.
Rate of Return
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.
One way to quantify risk is to measure the dispersion of returns around expected returns
variance or standard deviation
If two assets are positively correlated
they move together in the market (win/ win, lose / lose)
If two assets are negatively correlated
They offset eachother
Why is diversification important
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
Asset covariance
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
Minimizing Risk
-All risk can be diversified away when two assets are perfectly negatively correlated.
-Zero risk investment will always involve positive investment in both assets.
Assumption for investors
Are risk averse and prefer a high return.
Portfolio Possibility Curve
relation ship between return and risk
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.
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
Concepts behind CAPM
-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)
Capital Market Line
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.
Security Market Line
Graphs returns of the CAPM model. Relationship between the mean and beta, applies to portfolios whether they’re efficient or not.
Risk Free Asset
Guaranteed return without fear of losing the initial investment
Equilibrium Rate of Return
Hypothetical rate of return in a perfect equilibrium market
Market Portfolio
A theoretical portfolio that contains all assets and securities in the market.
3 Properties of Market Portfolio
Includes all investable assets, it is value weighted (each asset is weighted using its market weight), its efficient (invested to get the highest returns).
Separation theorem
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)
Why does the security market line (SML) describe the capital asset-pricing model (CAPM) equilibrium relationship between risk and expected rate of return
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
CAPM
R= rfr + beta (rm - rfr)
FV (compound)
PV x (1+r/n) ^ (nxt)
Discounting
(FV) 1/1+r^n
Limiting assumptions of CAPM
Assumes rfr (return without any risk), equilibrium market (no transaction costs), assumes risk and return prefrences.
Short selling
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.
