Chapter 8 part 2 my notes

Question 1

Risk is typically defined as

Answer 1

the possibility of incurring harm

Question 2

what is ex poste

Answer 2

past or historical returns

Question 3

what is ex ante

Answer 3

future or expected returns

Question 4

what does a return on investment consist of

Answer 4

two components 1. income yield 2. capital gain

Question 5

what is income yield

Answer 5

is the return earned in the form of a periodic cash flow received by the investors - the interest payments from bonds and - the dividends from equities

Question 6

what is the formula to calculate the income yield

Answer 6

Expected cash flows to be received / the purchase price CF/P

Question 7

What is the yield to maturity

Answer 7

is the return earned by buying a bond and holding it to maturity - it is also an expected return over that very long investment horizon

Question 8

What is the dividend yield

Answer 8

the cash that investors can expect to earn if the dividend payments over the next year are the same as they were over the previous period

Question 9

what is the formula for the dividend yield

Answer 9

current dividend payments / the current value of the index - it is not a forecast of future dividends

Question 10

what is a capital gain

Answer 10

the appreciation in price of an asset form some starting price, usually the purchase price or the price at the start of the year

Question 11

what is a capital loss

Answer 11

the depreciation in the price of an asset from some starting price, usually the purchase price or the price at the start of the year

Question 12

what is the formula for the capital gain (Loss) return or Yield

Answer 12

P1 - P0 / P0 (p I s the selling price or market price)

Question 13

true of false common shares should gain with inflation (capital gain_ over the long run as their prices and cash flows are not fixed

Answer 13

true

Question 14

the yield gap will increase or decrease with inflation

Answer 14

increase

Question 15

how do you get the complete picture of the return form investing in bonds versus common shares

Answer 15

use the total return equation

Question 16

what is the total return equation

Answer 16

income yield + capital gain (loss) yield

Question 17

Estimate the income yield, capital gain (or loss0 yield, and total return for the following securities of over the past year a. a $1,000 par value, 6% bond that was purchased one year ago for $990 and is currently selling for $995 b. A stock that was purchased for $20, provided 4 quarterly dividends of $0.25 each, is currently worth $19.50

Answer 17

CF = 0.6 x $1,000 = $60 P0 = $990 P1 = 995 Income yield = 60/990 =6.06% Capital gain return = (995 -990)/990 = .51% total return = 6.06% + .51% = 6.57% or total return = (60 + 995-990) / 990 = 6.57% b. CF = 0.25x 4 = $1.00 P0 = $20 P1 = 19.50 Income yield = 1/20 = 5% Capital gain (loss) return = (19.50 -20)/20 = -2.5% Total return = 5% - 2.5% = 2.5% or (1+19.50 -20) / 20 = 2.5%

Question 18

what are paper losses

Answer 18

capital losses that people do not accept as losses until they actually sell and realize them

Question 19

what is a day trader

Answer 19

someone who buys and sells based on intraday price movements

Question 20

what is mark to market

Answer 20

carrying securities at the current market value regardless of whether they are sold

Question 21

how do you measure ex post or historical returns

Answer 21

use arithmetic mean or geometric mean

Question 22

how do you calculate the arithmetic mean

Answer 22

add them all up and divide by how many (regular average)

Question 23

how do you calculate the geometric mean

Answer 23

add 1 to each number, multiply all the numbers together, then to the exponent of 1/n, -1

Question 24

which mean will be less the geometric mean or the arithmetic mean

Answer 24

geometric mean will always be less unless all the values are identical

Question 25

the more the returns vary, the (bigger or lesser) the difference between the Am and GM will be

Answer 25

bigger the difference b/w the Am and GM

Question 26

what is standard deviation definition

Answer 26

a measure of risk over all the observations; the square root of the variance

Question 27

what is standard deviation in other terms

Answer 27

movement away from the mean (avg)

Question 28

the larger the standard deviation the\_\_\_\_\_\_\_\_\_\_ _________ the return

Answer 28

more variable the return

Question 29

when the standard deviation is squared, we get a measure called

Answer 29

the variance

Question 30

the difference b/w Am and GM returns is approximately

Answer 30

half the variance

Question 31

which average (GM or AM) is more accurate

Answer 31

GM or compound rate of return provides the correct annual return amount

Question 32

The AM simply averages the annual rates of return without taking into account

Answer 32

simply averages the annual rates of return without taking into account the amount invested varies across time

Question 33

when should you use AM

Answer 33

when we are trying to estiamte the typical return for a given period such as a year

Question 34

when is it better to use GM

Answer 34

when we are interested in determining the "true" average rate of return over multiple periods - for instance, if we wanted to know our investment (and wealth) will grow over time - it measures the compounded rate of growth in our investmetn value over multiple periods

Question 35

what are expected returns - defnition

Answer 35

estimated future returns

Question 36

expected returns are often estimated based on what

Answer 36

historical averages

Question 37

what is an alternative to estiamting expected returns other than historical averages

Answer 37

use weighted average

Question 38

how do you calclaute the weighted average ex. suppose youa re given the following for two stocks, A and B where the return on each vires with the state of the economy Prob of Exp return on occurence Stock A stock B High growth 0.1 60% 5% Moderate growth 0.2 20% 25% No growth 0.5 10% 5% Recession 0.2 -25% 0% estiamte the expected return for each stock

Answer 38

ERa = 0.1(60)+ 0.2(20)+ 0.5(10) + 0.2(-25) = 10% ERb = 0.1(5) + 0.2 (25) + 0.5(5)+ 0.2(0) = 8% \* note it is similar to AM but how it is done is different (calclauting the probability) - we calclaute the probability of each event directly

Question 39

how is weighted average and AM different

Answer 39

weighted average we estiamte the probabilities for each event directly AM - assumes that each observation is equally likely,so the probability of each event is refelected in the number of times we observe it in the data

Question 40

for expected rates of return, short-term forecasts would use what and long run forecasts use

Answer 40

short term forecasts - use scenario based appraoch (because where we are today as huge impact on what is likely to happen over a short period) Long-run forecasts - historical approach tends to be better because it reflects what actually happens, even if it was not expected

Question 41

Long term forecasts for expected returns use

Answer 41

historical approaches like weighted average, am and GM

Question 42

what is the range

Answer 42

the difference between the maximuma and minimum values

Question 44

what is a more accurate measure of risk the range or standard deviation and why

Answer 44

standard deviaiton - because the range only uses two observations, the maximum and the minimum , whereas the standard deviation uses all the observations

Question 45

securities offering igher expected rates of return tend to be what

Answer 45

riskier

Question 46

what is the formula for standard deviation

Answer 46

you take the returns ie 4.3% . 3.2%, 5.6%, 10.5% and -7.6% and the arithmatic mean = 3.2% 1. take the (return % subtract the mean)+ (the next return - the mean) etc / number of returns - 1 then square root it

Question 47

what does the SD measure

Answer 47

it estiamtes the variability of the reutrns over the smaple period it also like the AM esitmate of the annual reutrn reflects the economic circumstances of the period over which it is estiamted therfore we also calclaute the scenario based SD as a measure of risk

Question 48

how do you measure (formula) scenario-based Standard deviation? and what else is it called

Answer 48

Ex ante measure - becasue we are explcility taking into account updated probabilites of the future events happening

Question 50

What is VAR

Answer 50

another commonly used measure of risk called Value at Risk - probability based measure of loss potential to a firm - represnets the estiamted loss (In money terms) tha tccoudl be exceeded (minimum loss) at a given level of probability - a lower proability translates into a highe rpotential loss, all else being equal

Question 51

what is portfolio

Answer 51

a collection of securities, such as stocks and bonds, tha tare combined an dconsidered a single asset

Question 52

what is modern portfolio theory MPT

Answer 52

the theory that securites should be managed within a portfoli, rather than individually, to create risk-reduction gains; also stipulates that investors should divderisy their investments so as not to be unnecessarily exposed to a single negative event (dont' put all your eggs in one basket)

Question 53

what does MPT do

Answer 53

takes the basic idea of don't put all your eggs in one basket and operationalizes it to show how to form portfolios with the highest possible expected rate of return for any given level of risk

Question 54

how do you calclaute the estimating expected portfolio return

Answer 54

add both portfolios up and divide by the total ie 600 + 1400 = 2,000 weighted avg amout invested in Portfolio a = 600 / 2000 = .3 weighted avg. amount invested in Portfolio b = 1,400 / 2,000 = .7 next take the estiamted expected return for each ie A = 10% and B = 8% (0.3)(10%) + (0.7) (8%) = 8.6%

Question 55

what is covariance

Answer 55

a statistical measure of the correlation of the fluctuaitons of ht eannual rates of return of different investments

Question 56

how do you calcluate covariance

Answer 56

add

Question 58

is the portfolio SD less or more than the weighted average of the SD of each individual security

Answer 58

always less than except one special case

Question 59

what is correlation coefficent

Answer 59

a statistical measure that identifies how security returns move in relation to one another

Question 60

although covariance provides a sueful measure of the realtionship of the co-movements of returns on individual securities, it is difficult to interpret what

Answer 60

intuitively because as in the case iwth the variance, the unit is perecent squared. fortunatley, covariance is related to another statistical measure, the correlation coeeficient whcih can be interpretted more intuitievely

Question 61

what does a +1 correlation coefficent mean

Answer 61

perfect or positve correlation - move together (A increases B increases) - returns on securities tend to move together, - doesn't mean that they are ALWAYS together

Question 62

correlation coefficient - the clsoer the absolute value of the correlation coefficent is to one,

Answer 62

the stronger the relationship between the returns on the two securities in fact, +1 that is, perfect positive correlation - and we know thte return on one security, we can predict the return on the other security with certainty.

Question 63

exteme correlation coefficents do not occur for traditional common shares in practice becuase

Answer 63

returns dispaly positive correlations with one another, but are less than one. because securiteis tend ot follow the movement of the overall marekt

Question 64

when do correlations tend to be higher amoung securities

Answer 64

whose companies are simialr in nature, if htey are in the same industry, are about the same size, and so on

Question 65

as you movee negaive with standard deviaiton as the correlation moves negative what happens

Answer 65

standard deviation goes down, less risk Postive realtionship - standard deviation increase, more risk

Question 66

as you move postive correclation,

Answer 66

standard deviation increases, more risk

Question 67

the closer the corecclation coefficent is to 1 the

Answer 67

higher the %

Question 68

when we have a perfect postive correlation, the variablity changes in what way

Answer 68

a linear or straight line fashion with the portfolio weights

Question 69

if the realtionsip correlation is less than perfectly positve (negative correlation)it is

Answer 69

bowed - it becomes more bowed as as the correlation decreases ;until, with a perfect negative correlation we can remove all risk

Question 70

The perfect negative correlation case is of great importance to finacne because

Answer 70

it is the basis fo hedging (taking an offsetting postgin so as to minimize risk)

Question 71

although when you have two secuties are perfectly negatively correlated, we

Answer 71

do not create an equally weighted portfolio in wich we invest the same amount of money in each seucity

Question 72

only if the securities are equally risky, as well as being perfectly negatively correlated, we form

Answer 72

an equally balanced portfolio to remove risk

Question 73

efficency frontier

Answer 73

please review graph and notes pg 311