L2- Risk Flashcards
What is portfolio risk?
uncertainty or potential fluctuations in the value of a portfolio
COMPLEX RISK?????????
Statistical meaning of risk?
average spread (squared) around the
mean.
Economic meaning of Risk?
some risk is good other risk is bad. We
need a method for separating the good and the bad risk
How does the Capital Asset Pricing Model (CAPM) relate to risk?
The CAPM helps separate good and bad risk by providing a method for finding appropriate DR based on the risk of an investment.
How does the CAPM adjust the discount rate based on risk?
–DR > Risk free rate for good risk (to compensate for higher uncertainty)
–DR< Risk free rate for bad risk (indicating lower uncertainty and lower required returns).
Define Beta
covariance of portfolio returns divided by the variance of the market portfolio.
Discount rate equation
rfr + [cov(r,rm]/[var(rm)] * (E(rm)-rfr)
Simplified Discount rate equation
rfr + b[E(rm)-frf]
b=beta
Risk Measure (beta, i think)
[cov(r,rm)]/var(rm)
Alternative risk measure
correlation * SD(r)/SD(rm)
Formula for factor model
r=rfr + β1λ1 + β2λ2 +⋯+ βKλK
β1, β2,…, βk = factor loadings (sensitivity of the asset to each factor)
λ1, λ2,…, λk = factors (risk factors influencing the asset’s return)
What are the factors in the Fama-French 3-factor model:
–the market index
–is the return on a portfolio long in small-cap stocks and short in large-cap stocks
–the return on a portfolio long in high market-to-book
ratio stocks and short in low market-to-book ratio stocks.
What does the Capital Asset Pricing Model (CAPM) tell us about the discount rate?
The appropriate market based discount rate is a risk-adjusted discount rate
Why do we use a company’s cost of capital when evaluating the project
Often the company has the same risk as the
project under consideration
What happens if a firm uses its cost of capital to evaluate projects that have different risks than the company?
–it will discriminate against projects that are safer than the company risk
–and favour projects that are riskier than the company risk.
What is the potential issue when using the company’s cost of capital to evaluate a project with different risk levels?
Sometimes the risk is not the same, and in this case there is a potential
acceptance bias
What is the total return on the company’s capital
its operational income divided by its
total assets
What is the total income of a company split into
income for debt holders and income to equity holders
What is the formula for the total return on a company’s capital?
I/V= [Id/D * D/V] + [Ie/E * E/V]
I=income, V=value of firm, Id= income for debt holders, D= debt value, Ie= income for equity holders, E= equity value
What’s the WACC formula
R= [Rd * D/V] + [Re * E/V]
Rd= cost of debt, Re= Cost of equity, D=total debt, E= Total equity, V= total value (V+D)
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