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Financial Economics > E1 P2- Lectures 5-7 > Flashcards

E1 P2- Lectures 5-7 Flashcards

1
Q

What does a high standard deviation indicate?

A

That there is a lot of variance in the observed data around the mean

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2
Q

What type of standard deviation can be seen with blue-chip stocks?

A

Low, little variance and little risk

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3
Q

Example in this

What is one of the main benefits of standard deviation?

A

It helps investors identify underlying risk. If an investment option has an average annual return of 10% but in the last 3 years it has returned 50%, -15% and 5% then it is unlikely it will actually return 10%.

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4
Q

What is the formal measure of risk?

A

SD

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5
Q

How does portfolio theory help investors?

A

Offers the framework needed to build portfolios with an optimal risk-return profile

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6
Q

Define the covariance of returns

A

describes the linear relationship between the return of 2 securities

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7
Q

What does a positive and negative covariance show?

A

A positive covariance means asset returns move together, while a negative covariance means they move inversely.

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8
Q

When the correlation coefficient is equal to 0 what does it mean for 2 securities?

A

there is no linear relationship between them - their returns are independent

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9
Q

When does SD indicate an asset is risky?

A

SD is positive

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10
Q

What does the SD of a portfolio depend on ?

A

the ws - the share %
the p - the correlation of the asset’s returns

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11
Q

If p AB = 1 what does this mean for the portfolio?

A

It is risky because σP will always be above 0

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12
Q

what does it mean when a portfolio is dominated?

A

there are other portfolios offering a higher level of return for the same risk

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13
Q

What is the segment between the riskless portfolio called and what does it represent?

A

It is called the efficient frontier - showing the optimal balance between risk and return for a portfolio

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14
Q

What is the opportunity set?

A

the set of portfolios that can be obtained by combining A and B in different amounts

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15
Q

What is the role of an indifference curve in PT?

A

helps investors decide what portfolio on the efficiency frontier they want, ie which one has maximum utility

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16
Q

Does a low risk averse investor have a shallow indifference curve or steep?

A

shallow, highly risk averse has steep

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17
Q

How do investors choose between portfolios on an efficient frontier?

A

they choose the point at which their indifference curve is tangent to the efficient frontier

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18
Q

How does an investor know their utility functions?

A

Advisors may help them identify acceptable levels of risk through risk tolerance tests

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19
Q

How can portfolio diversification help investors?

A

Can reduce risk, however some risk will always persevere - systematic risk

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20
Q

What are the key assumptions of CAPM?

A
  • investors only differ over their preference toward risk
  • investors share the same efficient frontier
  • no taxes and transaction costs
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21
Q

How do you work out the market portfolio?

A

Draw a straight line from Er = rf and SD = 0, the point of tangency with the efficient frontier is the market portfolio, M.

the line itself is the CML

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22
Q

What is the the market portfolio ? (M)

A

-a theoretical bundle of investments that includes every asset in the market, each one proportionally represented according to its market value.

  • the most attractive portfolio of risky securities that are more efficient than the ones on the efficient frontier
  • in a perfect capital market, investors are only interested in holding M
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23
Q

What is Tobin’s Separation theorem?

A
  • states that investment happens in two stages:
    -1. find CML
    2. find optimal portfolio on it
24
Q

to do with risk

What is the Sharpe Ratio? word form

A

a measure of performance that indicates excess return per unit of risk

25
Q

T or F, In perfect capital markets all securities traded have different return-to-risk ratios

A

False. all the same

therefore, they should all have same risk-return tradeoff as M portfolio

26
Q

What does a security’s beta indicate?

A

a measure of the systematic risk of a security or portfolio compared to the market as a whole.

measures a security’s responsiveness to movements of the market portfolio

NON-DIVERSIFIABLE

27
Q

What is the market portfolio’s beta (B.M)?

A

1, because it’s compared to itself

28
Q

When does a securities beta show it is entirely risk-free?

A

when it = 0

29
Q

If a company has a beta of 2.57% and the market rises 10% how much does the company rise?

A

12.57%

30
Q

What is a Security Market Line? and what does it help indicate?

A

a securities E(r) as a function of its beta
- helps determine whether a security is over or under valued

31
Q

What is the Capital Asset Pricing Model (CAPM)?

A
  • identifies a theoretical relationship between a security expected returns and beta
32
Q

Difference between CAPM and CLM?

A
  • CAPM - relationship between a security expected returns and beta
  • CLM - relationship between portfolio expected return and SD
33
Q

When is a security undervalued (bad investment) and vice versa on a graph with SML?

A

when it falls below the line

above is good

34
Q

How do you find the risk-free rate (R.F) in practice?

A

either the short-term 90 day treasury bill rate (avr over 5 years) or the 5-10 year bond rate

35
Q

How do we find the expected market return E(R.M) in practice?

A

We must move from expected to actual using averages of actual returns, often over 5 years from places like FTSE100 and S&P500

we use the Single index model to do the first bit

36
Q

How do derivatives help investors reduce risk exposure?

A
  • enable investors to adjust their risk / return profiles, without having to trade in the underlying securities
  • companies and investors use them to hedge (reduce risk)
37
Q

Name two benefits of derivatives other than risk hedging.

A
  • not having to trade securities means they save high transaction costs
  • you do not miss out on gains if fears prove to be groundless
38
Q

Define derivatives

futures, forwards and options are all derivatives

A

an asset whose performance is derived from changes in the value of an underlying stock
- the legal right to compensation for changes in an underlyer that becomes the asset

common underlyers are commodities, shares, bonds, currencies, interest r

39
Q

What is the difference between a futures and forwards contract?

3 each

A

futures are traded on public exchanges
futures = low risk, high regulation
futures are settled daily, over the counter

forwards are between two private parties and taylor made
forwards = more risk due to low regulation
forwards are settled on maturity

40
Q

What are forward and futures

A
  • contracts that a certain thing will be exchanged at specified future time for a price specified today

both parties are obligated to hold up their end

41
Q

What are the two positions an investor maintains in futures and forwards?

A
  • long / buyers position - expects underlyer to increase in value
  • short / sellers position - expects underlyer to drop in value
42
Q

What is the inital margin?

A

The amount (margin) needed in your account to take a trade

usually in the region of 0.1 to 15 percent of the underlying value

43
Q

What is the maintenance margin?

A

The lowest amount (margin) you need in your account to maintain it

protects the party in the event of a default

44
Q

What is the variation margin?

A

Variation margin refers the amount of funds needed to ensure margin levels for trading.

45
Q

Define an option

A
  • gives the holder the right (but not obligation) to buy or sell a given amount of an asset on or before a given date, at prices agreed today
46
Q

What is the difference between European options and American Options ?

A
  • European options can be exercised only at expiry
  • American options can be exercised any time up to expiry
47
Q

What do in, at and out-the-money mean?

A

In = positive payoff when exercised
At= zero payoff
Out= negative paypff

48
Q

What is the diff between call and put option?

A

Call - gives holder right to buy a stock
Put - gives holder right to sell a stock

49
Q

Options means you don’t have to exercise it, however what will you always be subject to? Y

A

The premium, so if you avoid losing or only gain a little you still pay the premium

Profit = payoff - premium

50
Q

On a long call option graph, where is the break-even point?

A

Where the profit curve intercepts X axis

51
Q

You buy a long put option for 5x 200 p a share, at a premium of 5p per share and the share drops to 0p. What is your profit after exercising the option?

A

975 p

52
Q

How can you hedge with options?

A
  • if you own shares, you can by a protective put option that limits your losses to only the intrinsic value + the premium whilst still keeping your profits unlimited minus the premium
53
Q

What is the SD, correlation with the market portfolio and the beta of the risk-free asset?

A

The risk-free asset has zero standard deviation.
The risk-free asset has zero correlation with the market portfolio.
The beta of the risk-free asset is 0.

ALL 0

54
Q

In CAPM how do you measure risk?

In standard models it is SD

A

Beta

55
Q

What is the protective put strategy?

A

It is where a put option is purchased of a particular asset to hedge any ownership of this asset. Losses are capped but gains remain unlimited

Financial Economics (11 decks)

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