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FN1 corporate finance > Chapter 8 part 2 my notes > Flashcards

Chapter 8 part 2 my notes Flashcards

1
Q

Risk is typically defined as

A

the possibility of incurring harm

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2
Q

what is ex poste

A

past or historical returns

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3
Q

what is ex ante

A

future or expected returns

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4
Q

what does a return on investment consist of

A

two components 1. income yield 2. capital gain

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5
Q

what is income yield

A

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

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6
Q

what is the formula to calculate the income yield

A

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

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7
Q

What is the yield to maturity

A

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

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8
Q

What is the dividend yield

A

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

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9
Q

what is the formula for the dividend yield

A

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

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10
Q

what is a capital gain

A

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

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11
Q

what is a capital loss

A

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

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12
Q

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

A

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

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13
Q

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

A

true

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14
Q

the yield gap will increase or decrease with inflation

A

increase

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15
Q

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

A

use the total return equation

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16
Q

what is the total return equation

A

income yield + capital gain (loss) yield

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17
Q

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

A

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%

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18
Q

what are paper losses

A

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

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19
Q

what is a day trader

A

someone who buys and sells based on intraday price movements

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20
Q

what is mark to market

A

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

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21
Q

how do you measure ex post or historical returns

A

use arithmetic mean or geometric mean

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22
Q

how do you calculate the arithmetic mean

A

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

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23
Q

how do you calculate the geometric mean

A

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

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24
Q

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

A

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

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25
Q

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

A

bigger the difference b/w the Am and GM

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26
Q

what is standard deviation definition

A

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

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27
Q

what is standard deviation in other terms

A

movement away from the mean (avg)

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28
Q

the larger the standard deviation the__________ _________ the return

A

more variable the return

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29
Q

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

A

the variance

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30
Q

the difference b/w Am and GM returns is approximately

A

half the variance

31
Q

which average (GM or AM) is more accurate

A

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

32
Q

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

A

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

33
Q

when should you use AM

A

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

34
Q

when is it better to use GM

A

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
35
Q

what are expected returns - defnition

A

estimated future returns

36
Q

expected returns are often estimated based on what

A

historical averages

37
Q

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

A

use weighted average

38
Q

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

A

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
39
Q

how is weighted average and AM different

A

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

40
Q

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

A

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

41
Q

Long term forecasts for expected returns use

A

historical approaches like weighted average, am and GM

42
Q

what is the range

A

the difference between the maximuma and minimum values

43
Q
A
44
Q

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

A

standard deviaiton

  • because the range only uses two observations, the maximum and the minimum , whereas the standard deviation uses all the observations
45
Q

securities offering igher expected rates of return tend to be what

A

riskier

46
Q

what is the formula for standard deviation

A

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

47
Q

what does the SD measure

A

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

48
Q

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

A

Ex ante measure

  • becasue we are explcility taking into account updated probabilites of the future events happening
49
Q
A
50
Q

What is VAR

A

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
51
Q

what is portfolio

A

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

52
Q

what is modern portfolio theory MPT

A

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)

53
Q

what does MPT do

A

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

54
Q

how do you calclaute the estimating expected portfolio return

A

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%

55
Q

what is covariance

A

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

56
Q

how do you calcluate covariance

A

add

57
Q
A
58
Q

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

A

always less than except one special case

59
Q

what is correlation coefficent

A

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

60
Q

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

A

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

61
Q

what does a +1 correlation coefficent mean

A

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
62
Q

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

A

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.

63
Q

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

A

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

64
Q

when do correlations tend to be higher amoung securities

A

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

65
Q

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

A

standard deviation goes down, less risk

Postive realtionship - standard deviation increase, more risk

66
Q

as you move postive correclation,

A

standard deviation increases, more risk

67
Q

the closer the corecclation coefficent is to 1 the

A

higher the %

68
Q

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

A

a linear or straight line fashion with the portfolio weights

69
Q

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

A

bowed

  • it becomes more bowed as as the correlation decreases ;until, with a perfect negative correlation we can remove all risk
70
Q

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

A

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

71
Q

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

A

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

72
Q

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

A

an equally balanced portfolio to remove risk

73
Q

efficency frontier

A

please review graph and notes pg 311

FN1 corporate finance (44 decks)

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