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zFundamentals of Corporate Finance > Chapter 13 > Flashcards

Chapter 13 Flashcards

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1
Q

How do we calculate expected return?

A

(Probability * Rate of Return) + (Probability * Rate of Return) + …

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2
Q

What is a portfolio?

A

A group of assets such as stocks and bonds held by an investor.

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3
Q

What is portfolio weight?

A

The percentage of a portfolio’s total value that is invested in a particular asset.

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4
Q

How do we calculate portfolio weight?

A

Asset 1 = $50
Asset 2 = $150
The portfolio weight % for Asset 1 is $50/$200 = 0.25 or 25%

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5
Q

How do we calculate risk premium?

A

Risk Premium = Expected Return - Risk-free rate

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6
Q

How do we calculate variance?

A

Variance = Probability(Rate of Return - AVG Rate of Return)^2
+ Probability(Rate of Return - AVG Rate of Return)^2 + …

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7
Q

How do we calculate Total Return?

A

Total Return = Expected Return + Unexpected Return

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8
Q

Total return differs from expected return because:

A

of surprises, or “news”

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9
Q

What is an announcement?

A

The release of information not previously available. Announcements have two parts: the expected part and the surprise part.

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10
Q

What is the expected part and the surprise part?

A

The expected part is “discounted” information used by the market to estimate the expected return, while the surprise is news that influences the unexpected return.

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11
Q

What is discounted information?

A

It’s information that is already included in the expected return (and the price). The tie-in to efficient markets is obvious. The assumption here is that markets are semi-strong efficient.

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12
Q

Risk consists of surprises. There are two kinds of surprises:

A
  1. Systematic risk

2. Unsystematic risk

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13
Q

What is systematic risk?

A

It is a surprise that affects a large number of assets, although at varying degrees. It is sometimes called market risk.

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14
Q

What is unsystematic risk?

A

It is a surprise that affects a small number of assets (or one). It is sometimes called unique or asset-specific risk.

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15
Q

Changes in GDP, interest rates, and inflation are examples of __________ risk. Strikes, accidents, and takeovers are examples of __________ risk.

A

Systematic

Unsystematic

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16
Q

__________ variability can be quite different from the variability of __________ __________.

A

Portfolio

individual securities

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17
Q

A typical single stock on the NYSE has a standard deviation of annual returns around ____%, while the typical large portfolio of NYSE stocks has a standard deviation of around ____%.

A

49

20

18
Q

What is the principle of diversification?

A

States that combining imperfectly correlated assets can produce a portfolio with less variability than the typical individual asset.

19
Q

The portion of variability present in a single security that is not present in a portfolio of securities is called __________ risk. The level of variance that is present in portfolios of assets is __________ risk.

A

diversifiable

nondiversifiable

20
Q

When securities are combined into portfolios, their __________ risks tend to cancel out, leaving only the variability that affects all securities to some degree.

A

unsystematic (or unique)

21
Q

Thus, diversifiable risk is synonymous with __________ risk.

A

unsystematic

22
Q

Large portfolios have little or no __________ risk.

A

unsystematic

23
Q

__________ risk cannot be eliminated by diversification since it represents the variability due to influences that affect all securities to some degree.

A

Systematic

24
Q

Therefore, nondiversifiable risk and _________ risk are the same.

A

systematic

25
Q

How do we calculate total risk?

A

Total risk = nondiversifiable risk + diversifiable risk = systematic risk + unsystematic risk

26
Q

What is the systematic risk principle?

A

The reward for bearing risk depends only on the systematic risk of the investment.

27
Q

The expected return on an asset depends on that asset’s __________ risk.

A

systematic

28
Q

No matter how much total risk an asset has, its expected return depends only on its __________ risk.

A

systematic

29
Q

What is the Beta coefficient?

A

measures how much systematic risk an asset has relative to an asset of average risk

30
Q

A riskless asset has a beta of ____.

A

0

31
Q

What is the equation for a line?

A

y = mx + b

where:
y = expected return
x = beta
m = slope = risk-premium per unit of beta
b = y-intercept = risk-free rate
32
Q

What is the reward-to-risk ratio?

A

It is the expected return per unit of systematic risk. In other words, it is the ratio of risk premium to systematic risk.
[E(Ri) - RF]/Bi

33
Q

The basic argument is that since systematic risk is all that matters in determining expected return, the reward-to-risk ratio must be __________ for all assets. If it were not, people would buy the asset with the higher reward-to-risk ratio (driving the price ___ and the return ___).

A

same
up
down

34
Q

What is the security market line?

A

The line that gives the expected returns/systematic risk combinations of assets in a well functioning, active financial market.

35
Q

What is the capital asset pricing model (CAPM)?

A

The equation of the SML showing the relationship between expected return and beta.

36
Q

What is the equation for CAPM?

A

E(R) = RF + [E(RM) - RF] x B

37
Q

The CAPM states that the expected return for an asset depends on:

A
  1. The time value of money, as measured by RF
  2. The reward per unit risk, as measured by E(RM) - RF
  3. The asset’s systematic risk, as measured by B
38
Q

What is the cost of capital?

A

The minimum expected return an investment must offer to be attractive. Sometimes referred to as the required return.

39
Q

What is market risk premium?

A

The slope of SML - the difference between the expected return on a market portfolio and the risk-free rate. (i.e. E(RM) - RF)

40
Q

What is an expected return?

A

The return on a risky asset expected in the future.

zFundamentals of Corporate Finance (15 decks)

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