Equity

Question 1

What are the five main factors driving stock returns?

Answer 1

1. Market factor – general market movements.
   
   2. Momentum – continuation of past price trends.
   3. Size – small-cap stocks often outperform large-caps.
   4. Value – stocks with high book-to-market ratios tend to outperform.
   5. Quality – profitability, stable earnings, and shareholder-friendly policies.

Question 2

What does the CAPM determine?

Answer 2

Expected returns as a function of systematic risk (beta).

Question 3

What is the formula for CAPM?

Answer 3

E(Ri) = Rf + Bi(E(Rm) - Rf)

Question 4

What does CAPM assume about the relationship between expected return and beta?

Answer 4

It is linear—higher beta means higher expected return.

Question 5

What is the expected return of a stock with \beta = 0?

Answer 5

The risk-free rate (R_f).

Question 6

What is the expected return of a stock with \beta = 1?

Answer 6

The expected market return (E(R_m)).

Question 7

What is the Betting Against Beta (BAB) strategy?

Answer 7

1. Buy low-beta (safe) stocks and short high-beta (risky) stocks.
   
   2. Adjust the portfolio so that both the long and short sides have a beta of 1.

Question 8

Why does BAB work?

Answer 8

Many investors avoid leverage, preferring risky stocks over applying leverage to safe stocks. This inflates risky stock prices and reduces demand for safe stocks.

Question 9

What is the Size Factor?

Answer 9

Small-cap stocks tend to outperform large-cap stocks over time.

Question 10

Why do small-cap stocks require higher returns?

Answer 10

1. Lower liquidity.
   
   2. Higher volatility.
   3. Greater risk of informed trading.
   4. Higher default risk.

Question 11

How is market capitalisation calculated?

Answer 11

stock price x number of shares outstanding

Question 12

What is value investing?

Answer 12

Buying stocks that are undervalued based on fundamental analysis.

Question 13

What is the key metric used in value investing?

Answer 13

Book-to-Market Ratio (B/M) = book value of assets / market capitalisation

Question 14

High B/M

Answer 14

Value stocks (undervalued)

Question 15

Low B/M

Answer 15

Growth stocks (overvalued)

Question 16

What are the four characteristics of quality stocks?

Answer 16

1. Profitability – high earnings relative to assets.
   
   2. Growing Profits – consistent earnings growth.
   3. Safety & Stability – stable and predictable earnings.
   4. Shareholder Payouts – dividends or buybacks.

Question 17

What characterizes growth stocks

Answer 17

• High earnings growth.
  
  • High stock prices.
  • Low book-to-market ratio.
  • Often found in sectors like technology (e.g., Facebook).

Question 18

What does the Fama-French Three-Factor Model add to CAPM?

Answer 18

1. SMB (Small Minus Big) → Captures the size premium (small-cap outperformance).
   
   2. HML (High Minus Low) → Captures the value premium (high B/M outperformance).

Question 19

What does SMB measure?

Answer 19

Performance of small stocks relative to large stocks.

Question 20

What does HML measure?

Answer 20

Performance of value stocks (high B/M) relative to growth stocks (low B/M).

Question 21

What is the overreaction hypothesis?

Answer 21

• Good news → Stock price rises too far.
  
  • Bad news → Stock price falls too far.

Question 22

How can traders profit from long-term reversals?

Answer 22

• Buy past losers (undervalued stocks).
  
  • Short past winners (overvalued stocks).

Question 23

What is the momentum effect?

Answer 23

Good news today → Price rises today.
* Price movement is too small, so it continues rising tomorrow.

Question 24

What is delayed overreaction?

Answer 24

• Good news → Price rises today.
  
  • Investors jump in later, causing further price increases.