Exam 3 Flashcards
Asset Allocation
How an investor spreads portfolio dollars among assets.
Correlation
The tendency of the returns on two assets to move together.
Moving up and down together - Positive correlation
Moving opposite directions together - Negative correlation
The lower the correlation, the greater the gain from diversification.
Efficient Portfolio
A portfolio that offers the highest return for its level of risk. A portfolio plotted above the minimum variance portfolio.
Portfolio
Group of assets such as stocks and bonds held by an investor.
Investment Opportunity Set
Collection of possible risk-return combinations available from portfolios of individual assets.
Markowitz Efficient Frontier
The set of portfolios with the maximum return for a given standard deviation.
The set of risky portfolios with the minimum standard deviation for a given return.
Principle of Diversification
Spreading an investment across a number of assets will eliminate some, but not all, of the risk.
Portfolio Variance Calculation (Example of Three stocks)
(Squared % invested stock A x Squared standard deviation stock A) +
(Squared % invested stock B x Squared standard deviation stock B) +
(Squared % invested stock C x Squared standard deviation stock C) +
(2 x % Invested Stock A x % Invested Stock B x % Invested Stock C x Standard deviation A x Standard Deviation B x Standard Deviation C x Correlation)
Systematic Risk
Affects almost all assets in the economy at least to some extent
Unsystematic Risk
Affects only a small number of assets
Unexpected Return
Total return - Expected return
Beta coefficient
Measure of the relative systematic risk of an asset. Assets with betas larger (smaller) than 1 have more (less) systematic risk than average
Beta of 1 = average asset
Increased Beta, while it means greater systematic risk, should also normally indicate increased expected returns
Capital Asset Pricing Model
A theory of risk and return for securities in a competitive capital market. States that the expected return for an asset is dependent on 3 things:
- Pure time value of money (risk-free rate)
- Reward for bearing systematic risk (Market risk premium)
- Amount of systematic risk (asset Beta)
Security Market Line
Graphical representation of the linear relationship between systematic risk and expected return in financial markets.
Expected Return = Risk-Free Rate + (Market Risk Premium x Asset Beta)
Systematic Risk
Affects almost all assets in the economy at least to some extent (also called market risk)
Since it effects almost all assets, it can’t be diversified away
Covariance
A measure of the tendency of two things to move together
Calculated by taking the sum of the products of the deviations divided by n-1
Can be translated into correlation by dividing it by the product of the asset and market standard deviations
Market Risk Premium
The risk premium on a portfolio made up of everything in the market
Standard Deviation vs Beta as measurements of risk
While standard deviation is a measurement of total risk (high standard deviation = high total risk), Beta measures only systematic risk (Beta > 1 is high risk). So if there’s a difference in comparison, it must have something to do with unsystematic risk.
Ex: Stock A has a lower Beta than Stock B but also has a higher standard deviation. That would mean stock A has less systematic risk but more unsystematic risk.
Portfolio Beta Calculation
Sum of each individual (Asset weight x Asset Beta) in the portfolio
Reward to Risk Ratio (Definition and Equation)
The risk premium “per unit” of systematic risk
(New Expected Return - Old Expected Return)/Beta
You want a higher Reward to Risk Ratio
Must be the same for all assets in a competitive market
Beta and market sensitivity
Higher beta is more market sensitive, lower is less
Information Ratio
Alpha divided by tracking error.
Jensen’s Alpha
Actual portfolio return - [Risk free rate + ((Actual return - risk-free rate) x Beta)]
Performance Evaluation
The assessment of how well a money manager achieves a balance between high returns and acceptable risks
Raw Return
States the total percentage return on an investment with no adjustment for risk or comparison to any benchmark.
R-Squared
A portfolio’s or security’s squared correlation to the market or benchmark. Represents the percentage of the fund’s movement that can be explained by movements in the market.
Sharpe Ratio
Measures investment performance as the ratio of portfolio risk premium over portfolio return standard deviation. Looks at total risk.
(Raw Total Return - Risk Free Return)/Standard Deviation
Investment Risk Management
Concerns a money manager’s control over investment risks, usually with respect to potential short-run losses.
Treynor Ratio
Measures investment performance as the ratio of portfolio risk premium over portfolio beta. Looks at systematic risk.
(Raw Total Return - Risk Free Return)/Beta
Normal Distribution
A statistical model for assessing probabilities related to many phenomena, including security returns.
10K
File submitted to SEC annually, including balance sheet, income statement, and cash flow statement
10Q
File submitted to SEC quarterly, except on quarter where 10K is submitted, including balance sheet, income statement, and cash flow statement.
Regulation FD (Fair Disclosure)
Requires companies making a public disclosure of material non- public information to do so fairly without preferential recipients.
Material Nonpublic Information
Any information that could reason- ably be expected to affect the price of a security
Balance Sheet
Accounting statement that provides a snapshot view of a company’s assets and liabilities on a particular date.
Income Statement
Summary statement of a firm’s revenues and expenses over a specific accounting period, usually a quarter or a year
Cash Flow Statement
Analysis of a firm’s sources and uses of cash over the accounting period, summarizing operating, investing, and financing cash flows.
Current Asset
Current assets are cash or items that will be converted to cash or be used within a year
Ex: Inventory, supplies, materials, accounts receiveable
Fixed Asset
Fixed assets have an expected life longer than one year and are used in normal business operations.
Tangible (property, plant, equipment)
Intangible (rights, patents, licenses)
Equity
Ownership interest in the company
Paid-In Capital: Form of equity which represents the amount received by the company from issuing common stock
Retained earnings: Accumulated income not paid out as dividends but instead used to finance company growth.
Income
The difference between a company’s revenues and expenses, used to pay dividends to stockholders or kept as retained earnings within the company to finance future growth.
Net Income Equation
Net Income = Dividends + Retained earnings
Operating Cash Flow
Cash generated by a firm’s normal business operations
Different than Net Income because it does include noncash things like depreciation
Investment Cash Flow
Cash flow resulting from pur- chases and sales of fixed assets and investments.
Financing Cash Flow
Cash flow originating from the issuance or repurchase of securities and the payment of dividends
Gross Margin Ratio
Gross Profit/Net Sales
Operating Margin Ratio
Operating Income/Net Sales
Return on Assets (ROA)
Net Income/Total Assets
Return on Equity (ROE)
Net Income/Shareholder Equity
Book Value Per Share (BVPS)
Shareholder Equity/Shares Outstanding
Earnings Per Share (EPS)
Net Income/Shares Outstanding
Cash Flow Per Share (CFPS)
Operating Cash Flow/Shares Outstanding
Price-Book (P/B) Ratio
Stock Price/BVPS
Price-Earnings (P/E) Ratio
Stock Price/EPS
Price-Cash Flow (P/CF) Ratio
Stock Price/CFPS
Market Risk Premium
Expected Market Return - Risk-Free Rate
In the Capital Asset Pricing Model (CAPM), what is the return for an asset with a Beta of 1?
The market return
