Financial Markets and the Pricing of Risk (Week 5) Flashcards
What is a stock return?
The percentage increase in value of an investment per $ initially invested in an asset
For a stock
= Dividend Yield + Capital Gains Rate
Assume BFI stock currenly trades for $100 per share.
In one year, there is a 25% chance that the sare price will be $140 (returns is 40%), a 50% chance it will be $110 (return is 10%) and a 25% chance it will be $80 (return is -20%).
Expected Return is calculated as a weighted average of the possible returms, where the weigjts correspond to the probabilities.
Variance
The expected squared deviation from the mean
Standard Deviation in Finance
(Volatility)
The square root of the variance
What is the advantage of using SD over Variance ?
SD is expressed in same unit (scale) as the values
What does a higher variance mean?
The values are more “spread out” around their expected value.
Suppose AMC stock is equally likely to have a 45% return or a -25% return. What are its expected return and volatility?
Larger stocks tend to have _____ volatility than smaller stocks.
lower
Two types of news can affect the future cash-flows of a company (and thus its expected returns)
- Firm-specific news
- Market-wide news
What is idiosyncratic risk?
- Firm-specific/diversifiable risk
- Arises due to firm-specific factors (news)
What is Systematic risk?
- Undiversifiable/market risk
- Arises due to market-wide factors (news)
What is Diversification? What is the result?
The process of combining many stocks into a large portfolio. e.g. spending 1k on a number of different stocks rather than stocks from a single company.
The result of diversification is that firm-specific risks for each stock will average out and overall volatility will be reduced.
The systematic risk, however, will affect all firms and will not be reduced.
What is Risk Premium?
Compensation for holding a risky asset (e.g. a high-tech stock) instead of a risk-free asset (e.g. a government bond).
The risk premium is the additional return that we can expect an asset to earn (compared to a risk-free asset) as a compensation for the additional risk in that asset.
Expected return = risk-free return + Risk Premium
What is the risk premium for diversifiable risk?
ZERO.
- Investors are not compensated for holding firm-specific risk, because it is easy to get rid of it (by diversifying, putting several stocks in a portfolio).
- If the diversifiable risk of stocks were compensated with an additional risk premium then investors could buy the stocks, earn the additional premium and simulatenously diversify and eliminate the risk.
- As many investors would try to do that, the price of these stocks will increase quickly, which means that the expected return (and risk premium) will decrease quickly.
With regards to risk, what is Beta?
The Sensitivity of a stock’s expected returns to systematic risk.
The expected percent change in the return of a security for a 1% change in the return of the market portfolio.
What is the equation for the Beta for asset i?
What is the equation for CAPM?
What is the equation for abrnomal retuns (returns in excess of compensation for risk), or ‘alpha’?
