Cleanup Flashcards
Relate the value of the firm in terms of raising funds
The assets undelying the firm is the ultimate decider for value.
The firm will be able to raise an amount equal to the cash flows that can be received from the assets.
But it is actually mroe complex than that: It is not entirely about hte assets, but it also incldues the value of these assets that equity investors and debt ivnestors ultimately end up with. For instance, if the firm is all equity financed, and no taxes, then it is easy to see that the assets’ produced value is equal to the amount of capital they can raise. However, if we include taxes on the corporate level, investors are left with the part of the cash flow that does not go to taxes. In other words, taxes reduce the amount of capital that the assets will be able to raise. If the tax rate is 35%, the assets’ value is basically 100-35=65% of the original produced cash flow. Thus the benefit of tax shields, but that is another story.
Then we include the effect of personal taxes. If investors are all taxed at 10% of all income, then they will actually only receive (1-0.35)x(1-0.1)=0.585 = 58.5% of the original cash flow produced by the assets. This means that when equity investors would consider a position in the firm’s equity, this is the amount they consider as given to them.
It would be the same case if the firm used leverage, but now we have teh additional interest tax shield, and the addition of leverage would introduce other types of costs as well (increased risk of amplified returns, potentially distress costs as well). However the point remains the same. Both debt investors and equity investors loose a part of the cash flow from the corporate taxation AND the personal taxation. Actually that is not completely true, as debt is not taxed at corporate level, which means that debt investors’ cash flows remain the same regardless of corporate tax, but then their personal taxation is typically higher than the personal taxation of the equity investors.
Are all types of income taxed equially?
No. Interest income has typically been taxed more heavily than the taxation on capital gain.
elaborate on the effective tax advantage of debt
there is the formula:
t = 1 - (1-tcorp)(1-tequity)/(1-tdebt)
What does it tell us?
By including the 1 as (1-tdebt), we’d get:
percentage cash flow remains after debt, less percetnage of cash flow remains after equity, deivided by percentage cash flow remains after debt.
So, it tells us the relative tax advantage of distadvantage to using debt. If the result is negative, there is a disadvantage to using debt.
If the result is positive, there is a tax advantage of debt.
elaborate on the CML
There is only one difference between SML and CML. Both use the greatest Sharpe ratio (tangent portfolio, market portfolio) as a basis, and multiply by their own measure of risk.
CML use volatility.
SML use volatility multiplied by the correlation between the specific stock and the market/tangent portfolio.
This means that the two lines yield different results. CML yield a relationship between volatility of a stock and the return. SML yield a relationship between beta and required returns.
We know that volatility alone is not good enough. it is better to use beta for such purposes (unless the portfolio is well diversified), which is why SML is a better result in terms of the relation between risk and return.
In terms of the CML: We expect individual stocks to have a performance that is worse (per unit of volatility) compared to the CML line. Therefore, the CML can be regarded as an upper limit. If we see stocks outperforming the CML, we say that they have positive alpha, which basically means that they have outperformed the market. In such cases, they are located above (to the left) of the CML. In such cases, we can expect investors to take initiative and buy it until its return decrease as a result of the higher price etc.
The sum up: CML assumes a relationship between volatility and returns. We know that only good diversified portfolios have volatility as a measure of risk, and because of this, we only expect fully diversified portfolios to lie at the CML. All other stocks are expected below it
CAPM assumes efficient market portfolio. what happens if we do not have such a portfolio?=
We need to find alternative ways of building the efficient portfolio. I
Explain the background/motivation for factor models
the hypothesis is that market risk (economic swings) affect stocks, but they are not the only thing affecting stocks. The assumption basically say that CAPM is too simple, and that investors consider other sources of risk than just checking how it moves with the overall market.
Size, value, momentum are examples of factors other than market risk that influence the decision making.
Why do we care about the expected returns of marketable securities?
two reasons:
1) Cost of capital
2) Returns we will be compensated with
how is the cmplexity of computing/identifying efficient portfolios?
Very difficult, because we cannot easitmate the expected return and standard deviation with great accuracy.
Elaborate on factor portfolios
A factor portfolio refer to differnet identified portfolios that are well diverisfied on their own, but not necessarily the efficient portfolio.
The goal is to combine them somehow to create a better portfolio.
Given factor portfolios with various returns, how do we find the expected return of an asset s that use all of these portfolios?
We extend CAPM to add a beta x Excess return for each beta/factor
What is a single factor model?
A single factor model is a model that use only one factor. Typically, the requirement for this factor will be that it can capture all the systematic risk.
Note that systematic risk is not necessarily the same as market risk.
Elaborate on multi-factor models
The point is that we use multiple factors to capture all the systematic risk.
The assumption is that using one factor might not be good enough.
What APT?
Arbitrage Pricing Theory. Explains the risk premium of an asset by considering multiple factors, typically macroeconomical factors.
elaborate on multi-factor models for risk in regards to investors
A great benefit of this scheme is that each investor can tailor the risk exposure in a way that fits his averse tendencies. By weighting certain factors more or less, this is easily done.
Such a strategy is referred to as Smart beta strategy,.
Explain the main argument made by advocators of the multi-factor risk models
Investors are naturally exposed to different kinds of risk already. Therefore, if he can identify an asset that has a lot of risk associated with it in terms of a risk factor that the investor is already well protected against, there might be significant premium there to make use of.
In other words, if you have the capacity to take on a certain type of risk, we will find the excess return there very favorable, as it is basically less risky to us.
elaborate on Fama-French-Carhart
Regarding the portfolios:
1) Market. Just as always from CAPM
2) The small minus big portfolio. We find it by consideting NYSE stocks, find median size, and divide into two equal sized portfolios (equal in terms of the number of stocks). Then we take a long position in the small portfolio and create it self financing by shorting the big one. Such a strategy is produced positive alpha historically.
3) High minus low. This is a Book-to-market strategy. we take the lower 30% percentile and make one, and then the higher 30% above the 70 percentile and make one. Then we take a long posiiton in the higher, and short the lower. has produced positive alpha historically.
4) prior one-year momentum. We long the 30% with the best returns the eyar before, and short the stocks that was lower 30% last year.
