Lecture 2&3

Question 1

Investing in Equity

Answer 1

1. Represents ownership in a firm
2. Earn return through stock price rising or dividends
3. Stockholders have a claim on all assets
4. Right to vote for the directors and on certain issues

Question 2

Common Stock

Answer 2

• Residual claim on firm’s assets
• Right to vote
• Entitled to common dividends

Question 3

Preferred Stock

Answer 3

• Priority claim on firm’s assets
• Don’t usually have a voting right
• Entitled to preferred (fixed) dividend

Question 4

Equity Advantage from Corporate finance perspective

Answer 4

• No repayment required
• No extra burden is borne
• No required monthly payment
• Risk is shared
• Companies can raise substantial funds

Question 5

Modern Portfolio Theory

Answer 5

• Only expected return and variance of returns are relevant in investment selection
• Utility from investment is comparable to the expected return and inversely comparable to the variance of returns

Question 6

1/N rule

Answer 6

Spread your eggs equally across as many baskets as possible

Question 7

Markowitz rule

Answer 7

Use as many baskets as possible and find the best number of eggs in each basket

Question 8

Kourtis and Markellos rule

Answer 8

Find the best baskets and then worry about how to spread you eggs

Question 9

Return vs risk in MPT

Answer 9

Expected returns have a linear relationship with standard deviation (risk) in MPT

Question 10

Diversification

Answer 10

• Diversification effect: generally, increasing number of investments in a portfolio reduces risk
• After about 20 investments, the reduction in risk is negligible
• Reduces Unique risk, not market risk

Question 11

Unique Risk

Answer 11

Refers to the specific conditions of a company

Question 12

Market Risk

Answer 12

Refers to the general economic conditions that may affect the performance of a company

Question 13

Correlation and diversification

Answer 13

If the investments in a portfolio have a correlation of -1, this provides the most benefits. Correlation of 1 provides no benefits

Question 14

International Diversification

Answer 14

• Can substantially reduce portfolio risk
• Each domestic stock market has some correlation with other stock markets
• A domestic investor will get more diversification from an investment in a market with a low correlation

Question 15

Capital Asset Pricing Model

Answer 15

• The risk of any asset is the risk that it adds to the market portfolio
• Risk can be measured by how much an asset moves with the market
• CAPM is the equilibrium model that underlines all modern financial theory

Question 16

CAPM assumptions

Answer 16

1. Individuals are price taker
2. Single-period investment horizon
3. Investments are limited to traded financial assets
4. No taxes or transactions costs
5. Information is costless and readily available to all investors
6. Investors are rational mean-variance optimisers
7. There are homogeneous expectations

Question 17

Resulting Equilibrium Conditions

Answer 17

• All investors hold the same portfolio for risky assets - Market Portfolio
• Risk premium on the market depends on the average risk aversion of all market participants
• Risk premium on an individual security is a function of its covariance with the market

Question 18

Market Portfolio

Answer 18

Contains all securities and the proportion of each security is its market value as a percentage of the total market value

Question 19

Power of Diversification

Answer 19

When n very large, the portfolio variance depends only on the covariance among assets