Financial Markets Correlation :C1M3 Flashcards
What is risk in the context of decision-making?
Risk refers to situations where the probabilities of potential outcomes are known.
How is uncertainty different from risk?
Uncertainty occurs when the probabilities of potential outcomes are unknown.
What is expected value (EV) in risk analysis?
In risk analysis, Expected Value (EV) is a key concept used to estimate the average or mean outcome of a decision or investment, taking into account the various possible outcomes and their associated probabilities.
What is expected value (EV) in risk analysis?
Variance measures the spread or variability of potential outcomes around the expected value.
What does the coefficient of variation (CV) indicate?
CV compares the standard deviation to the mean, showing relative risk per unit of expected return.
What is risk aversion?
Risk aversion is a preference for certain outcomes over risky ones, even if the expected value is higher for the risky option.
What is a risk-neutral decision-maker?
Someone who evaluates decisions solely based on their expected value, ignoring risk.
Define risk-seeking behavior.
A preference for risky options over certain outcomes, even if the expected value of the certain outcome is higher.
What are “stochastic profits”?
Profits subject to variability due to uncertain outcomes.
What role does the risk aversion coefficient (λ) play in decision-making?
It quantifies a decision-maker’s tolerance for risk in relation to potential variability of outcomes.
What is the EV-variance model?
A model that evaluates trade-offs between the expected value and the variance of outcomes.
What is the formula for certainty equivalent profits (πCE)?
What happens when the cost of debt equals the expected return on assets?
The firm may hold negative debt, preferring to lend equity rather than invest in risky assets.
Define the firm’s leverage ratio (l*).
The ratio of debt (D*) to equity (E).
How does increasing expected asset returns (ra) affect leverage?
It increases the optimal leverage ratio.
What is the impact of increasing the cost of debt (iD) on leverage?
It reduces the optimal leverage ratio.
How does a higher risk aversion coefficient (λ) affect leverage?
It reduces the firm’s willingness to take on debt, lowering leverage.
What happens to leverage when the firm’s equity increases?
The optimal leverage ratio decreases.
How does increased variance of asset returns (σa²) affect leverage?
It reduces the optimal leverage ratio.
What does a leverage ratio of 4.34 indicate compared to 0.78?
A firm with a lower risk aversion coefficient may accept higher leverage.
Why is capital structure important for a firm?
It determines the mix of debt and equity used to finance operations and growth.
What is the formula for optimal leverage ratio (l*)?
What does HQN’s data illustrate about optimal leverage?
That optimal leverage changes significantly based on variables like returns, cost of debt, and risk aversion.
How can risk preferences influence decision-making?
Individuals with different risk aversion levels may make varying choices even in the same circumstances.
What role does the standard deviation of returns (σa) play in risk analysis?
It measures the extent of variation in returns, influencing the firm’s risk assessment.
Why is it important to measure risk in both percentages and dollars?
The scale of measurement can affect the calculation and interpretation of risk aversion coefficients.
How does increasing the expected value of return on assets (ra) to 7% affect leverage?
It increases the optimal leverage ratio to 2.56.
What is a key takeaway about firms and risk?
Firms generally dislike risk and prefer stable, expected returns.
Why should managers explore their own risk preferences?
To make informed decisions that align with their comfort level regarding risk.
What is the main message about optimal leverage ratios?
They are highly sensitive to rates of return, cost of debt, and the decision-maker’s attitude toward risk.
What is diversification in finance?
Diversification is an investing strategy used to manage risk by spreading investments across different companies, industries, and asset classes.
What is the key goal of diversification?
The goal is to own investments that do not move in lockstep, reducing overall portfolio risk.
Why is perfect correlation undesirable in a portfolio?
Perfect correlation means all investments move together, eliminating diversification benefits.
How does a correlation of -1 affect a portfolio?
A correlation of -1 means perfect negative correlation, maximizing diversification benefits.
What is a “perfect hedge”?
A perfect hedge occurs when two securities are perfectly negatively correlated, reducing portfolio volatility to a minimum.
What happens to portfolio volatility as correlation decreases?
Portfolio volatility decreases as correlation decreases, enhancing diversification benefits.
What is the impact of zero correlation on portfolio returns?
Zero correlation means the returns of securities are independent, providing diversification benefits without a linear relationship.
What is the standard deviation formula influenced by?
The formula is influenced by asset weights, individual volatilities, and the correlation between assets.