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COMM 221: Financial Markets > Lecture 3 Slides > Flashcards

Lecture 3 Slides Flashcards

1
Q

What is the risk-return tradeoff in finance?

A

The risk-return tradeoff is the concept that if you are to take on risk, you must be compensated for it.

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2
Q

How does the risk-return tradeoff apply to careers and investments?

A

The risk-return tradeoff applies to careers and investments by implying that taking on higher risk, such as performing dangerous jobs or investing in risky assets, should come with higher compensation or returns.

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3
Q

What is risk-shifting?

A

Risk-shifting is the process of transferring the risk of an activity, such as deep sea welding, to someone else who is willing to take on the risk, often by compensating them with a premium.

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4
Q

Why might society pay a premium for certain jobs?

A

Society might pay a premium for certain jobs to entice individuals to take on high-risk tasks that others are unwilling to do due to the associated dangers.

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5
Q

How can risk be measured in the context of a job or investment?

A

Risk in the context of a job can be measured by the likelihood of death or severe injury, while for an investment, it can be measured by the probability of loss.

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6
Q

What is a common measure of risk used in finance?

A

A common measure of risk used in finance is standard deviation, due to its simplicity and intuitive appeal.

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7
Q

What is the price of a risky investment where you have a 50% chance to earn $1m and 50% chance to earn zero?

A

The price of this investment should be the actuarial value, which is the expected value of the investment. In this case, it is $500,000 (0.5 * $1M + 0.5 * $0 = $500K).

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8
Q

How do profit-maximizing firms generally approach risk?

A

Profit-maximizing firms are often risk-neutral, meaning they neither overpay to take on risk nor overpay to avoid it. They focus on the raw average returns.

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9
Q

What is the actuarial value?

A

The actuarial value is the statistical expectation or average value of an investment, calculated as the sum of all possible outcomes weighted by their probabilities.

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10
Q

Why might humans not be risk-neutral like firms?

A

Humans generally tend to be risk-averse, meaning they prefer to avoid risk, and thus need to be enticed to carry risk, often requiring a risk premium.

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11
Q

What is a risk premium?

A

A risk premium is additional compensation paid to someone to entice them to take on risk that they would otherwise avoid.

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12
Q

How is the concept of actuarial value applied in the example provided?

A

In the example, the actuarial value of the investment is $500,000. If only $300,000 is charged, then the average gain for the investor is calculated as 0.5 * $700,000 + 0.5 * (-$300,000) = $200,000, which is the actuarial expectation minus the price paid ($500K - $300K = $200K).

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13
Q

What is priced risk?

A

Priced risk is a type of risk that has a risk premia greater than 0%, which cannot be eliminated by diversification and is considered systematic or non-diversifiable.

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14
Q

What is the role of the marginal investor regarding priced risk?

A

The marginal investor avoids priced risk as it cannot be diversified away.

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15
Q

How can systematic risk be managed if it cannot be eliminated?

A

Systematic risk can be traded in a complete market by paying a premium to another person to carry that risk.

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16
Q

What is unpriced risk?

A

Unpriced risk is a risk with a risk premia of 0% and is irrelevant to the marginal investor, as they neither avoid nor desire the characteristic it represents.

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17
Q

What are idiosyncratic risks?

A

Idiosyncratic risks are risks that are specific to a firm and can be diversified away, also known as firm-specific, diversifiable, or non-systematic risks.

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18
Q

What does adding more assumptions to the notion of priced and unpriced risk lead to?

A

It leads to the Capital Asset Pricing Model (CAPM).

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19
Q

What does CAPM describe?

A

CAPM describes the relationship between systematic risk and expected return for assets, particularly stocks.

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20
Q

Can diversifiable risk be completely eliminated in a portfolio?

A

No, even in a fully diversified portfolio, some systematic risk remains and it can be traded but not eliminated.

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21
Q

How is the price of taking systematic risk measured?

A

The price of taking systematic risk is another measure of the price of risk.

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22
Q

What is Sharpe’s 1964 CAPM expression?

A

It is an expression that connects an asset’s return with how much systematic risk it carries, using Beta (β) as the risk factor.

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23
Q

What does the CAPM equation look like?

A
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24
Q

What does the term ‘Beta (β)’ represent in CAPM?

A

Beta (β) represents the factor load or the measure of an asset’s systematic risk relative to the market.

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25
Q

How do you calculate the expected return using CAPM if Beta is 1.3, the market return is 10%, and the risk-free rate is 4%?

A
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26
Q

What does CAPM help to estimate in financial economics?

A

CAPM helps to estimate the cost of capital or to provide a trading recommendation.

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27
Q

What is the certainty equivalent (CEQ)?

A

The certainty equivalent (CEQ) is the guaranteed (100% likely) dollar amount that would make a person indifferent between that amount and a risky game.

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28
Q

How is the certainty equivalent (CEQ) related to risk aversion?

A

The less a person likes risk, the higher the CEQ. The more rewarding the game, the higher the CEQ.

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29
Q

What theory is used to find the certainty equivalent (CEQ)?

A

Expected Utility Theory (EUT) is used to find the CEQ.

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30
Q

How is expected utility calculated?

A
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31
Q

What does it mean to “invert the utility function” to find CEQ?

A

Inverting the utility function means finding the level of certain wealth that provides the same utility as the risky prospect.

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32
Q

What is a deductible in insurance terms?

A

A deductible is the initial amount of damage that is not covered by the insurance company.

It encourages policyholders to minimize risks.

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33
Q

Why are deductibles included in insurance policies?

A

Deductibles limit morale hazard by encouraging the policyholder to take steps to prevent loss since the initial losses are their responsibility.

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34
Q

What does it mean to be “indifferent” between being insured and uninsured?

A

Being indifferent means the expected utility of being insured equals the expected utility of being uninsured.

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35
Q

How is the insurance premium calculated using the certainty equivalent?

A

The insurance premium is calculated by equating the expected utility of being insured with the expected utility of being uninsured, and solving for the premium (P).

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36
Q

What is the role of subjective probability in insurance decisions?

A

Subjective probability is an individual’s estimation of the likelihood of an event, which influences their willingness to pay for insurance.

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37
Q

How do insurance companies determine the profit from providing insurance?

A

The profit is the difference between the price of the insurance and the actuarial cost of providing it, which includes the expected losses.

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38
Q

What is the actuarial cost of insurance?

A

The actuarial cost is the expected cost of losses, calculated as the probability of the loss times the amount of the loss.

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39
Q

Why might the expected utility theory (EUT) lead to different insurance premiums?

A

Different individuals have different utility functions and subjective probabilities, leading to variations in how much they value insurance and thus the premiums they are willing to pay.

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40
Q

What is the insurance premium (P) for full fire insurance with no deductible on a $600K home with a 1% fire probability?

A

The insurance premium (P) is $23,488, calculated by equating the expected utility of being insured and uninsured and solving for P.

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41
Q

How do changes in the probability of fire affect the insurance premium?

A

If the probability of fire increases, the insurance premium would also increase to account for the higher expected losses.

42
Q

What is an alternative to the certainty equivalent (CEQ) for measuring risk?

A

Standard deviation or the square root of variance of return is an alternative measure of risk.

43
Q

What assumption does the measure of standard deviation make?

A

It assumes that people dislike uncertainty and that the measure is stationary, meaning it remains constant over time.

44
Q

How can we compute standard deviation?

A

We can compute either the population or sample standard deviation.

45
Q

What is the formula for the population variance?

A
46
Q

What is the formula for the sample variance?

A
47
Q

Why is computing standard deviation by hand considered tedious?

A

Because it involves calculating the squared differences from the mean for each data point, summing them, and then taking the square root of the average of these squared differences.

48
Q

What is the average outcome of a 6-sided die?

A
49
Q

How is the population variance of a 6-sided die calculated?

A
50
Q

What is the standard deviation of the 6-sided die?

A
51
Q

Why is standard deviation easier to interpret than variance?

A

Because standard deviation is in the same unit as the mean, making it easier to understand the average distance from the mean.

52
Q

What is the effect of averaging two independent dice?

A

Averaging two independent dice diversifies the outcomes, reducing the variance and standard deviation, and creating a more stable average result.

53
Q

What is diversification in finance?

A

Diversification in finance is the process of mixing a portfolio of uncorrelated assets to reduce risk while maintaining the mean expected return.

54
Q

How does diversification affect the Sharpe ratio of portfolios?

A

Diversification improves the Sharpe ratio of portfolios by reducing portfolio variability without significantly impacting the mean expected return.

55
Q

How is the variance of many independent variables calculated?

A
56
Q
A
57
Q
A
58
Q

What are the limitations of using standard deviation as a measure of risk?

A

The limitations include its inadequacy in discrete distributions, its assumption of symmetry, and its dependency on the stationarity of data.

58
Q

Why is standard deviation not ideal for discrete distributions?

A

In discrete distributions, outcomes like 100% loss or doubling money are extreme and mean outcome and standard deviation may not accurately capture the risk.

59
Q

What is the problem with standard deviation’s assumption of symmetry?

A

Standard deviation treats outcomes above and below the mean equally, which may not accurately represent risk for cases like non-swimmers in deep water versus shallow water.

60
Q

What does stationarity mean in the context of standard deviation?

A

Stationarity means the statistical properties (mean, variance, etc.) of a distribution are constant over time, which is often not true in finance, making standard deviation less reliable.

61
Q

What is non-stationarity, and why is it important in finance?

A

Non-stationarity refers to changing distribution properties over time, meaning historical data may not accurately predict future risk, making standard deviation less effective.

62
Q

What is Value at Risk (VaR)?

A

Value at Risk (VaR) is a measure used to estimate the likelihood of a particular event, such as a financial loss, based on historical performance and the assumption that historical performance is representative of future performance.

63
Q

How can historical data be used in estimating risk using VaR?

A

Historical data can be used to determine the likelihood of various outcomes and then decide on the level of security or risk tolerance based on these probabilities.

64
Q

What is an example of using VaR in a physical context?

A

An example is estimating the risk of flooding by analyzing historical water levels and building a dike to a height that reduces the risk to an acceptable level.

65
Q

What is the caution regarding the stationarity assumption in VaR?

A

The stationarity assumption may not hold in all cases, such as with the effects of global warming on flood risks, making it important to note the potential for extreme values or changing conditions.

66
Q

What are risk factors in finance?

A

Risk factors are variables used to measure risk by estimating their effect on excess returns through models and regression analysis.

67
Q

What is the general form of a regression model used to estimate risk factors?

A
68
Q

What is the Capital Asset Pricing Model (CAPM)?

A

The CAPM is a model that relates the expected excess return of an asset to the excess return of the market, using a single factor, beta (𝛽).

69
Q

What does a high magnitude beta (𝛽) indicate about an investment?

A

A high magnitude beta indicates that the investment’s return is very sensitive to the factor being measured, suggesting higher risk and potentially higher return.

70
Q

How are factor models generally estimated?

A

Factor models are generally estimated by regression analysis to determine the impact of various factors on the excess returns of assets.

71
Q

What is the Capital Asset Pricing Model (CAPM) equation for expected return?

A
72
Q

How is the expected return on a stock calculated using CAPM?

A
73
Q

What is the Fama-French 5 factor model?

A

The Fama-French 5 factor model extends CAPM by including five factors:

market risk premium,
SMB (small minus big),
HML (high minus low),
RMW (robust minus weak),
and CMA (conservative minus aggressive).

74
Q

How is the required rate of return calculated using the Fama-French 5 factor model?

A
75
Q

How do you calculate the discount rate using CAPM?

A
76
Q

How do you compute the present value (PV) of an investment using the discount rate from CAPM?

A
77
Q

How does an increase in risk premium affect the present value of an investment?

A

An increase in risk premium raises the discount rate, lowering the present value of future cash flows. For instance, if the expected return rises to 19%, the PV decreases to

−4875.86.

78
Q

What can the CAPM model do besides simple valuation?

A

The CAPM model can identify deviations from model predictions and expect them to resolve over time, allowing for investment recommendations.

79
Q
A
80
Q

How can the CAPM model help identify underpriced and overpriced assets?

A

If an asset’s return is too high for its risk level, it is underpriced and its price will rise. Conversely, if an asset’s return is too low for its risk level, it is overpriced and its price will fall.

81
Q

What happens when an asset is identified as underpriced using the CAPM model?

A

The price of the underpriced asset will rise as investors buy it, and its expected return will drop to the equilibrium level.

82
Q

What happens when an asset is identified as overpriced using the CAPM model?

A

The price of the overpriced asset will fall as investors sell it, and its expected return will rise to the equilibrium level.

83
Q

What is the process of restoring CAPM equilibrium for an undervalued stock?

A

Investors buy the undervalued stock, driving up its price and driving down its expected return until equilibrium is restored.

84
Q

What is the process of restoring CAPM equilibrium for an overvalued stock?

A

Investors sell the overvalued stock, driving down its price and driving up its expected return until equilibrium is restored.

85
Q

Who are stakeholders influenced by corporate behavior?

A

Stakeholders include citizens, government, the environment, employees, bondholders, and others affected by corporate actions.

86
Q

What should a company’s Board of Directors (BoD) and Executive officers focus on?

A

They should focus on shareholder value maximization, but also consider the impact on other stakeholders.

87
Q

What are some standards for being a good corporate citizen?

A

Standards include Environment, Social, and Governance (ESG) concerns, which can sometimes align with value-maximizing behavior and benefit the community.

88
Q

Why should businesses worry about negative externalities?

A

Negative externalities can lead to punitive fines and settlements, encouraging businesses to act responsibly.

89
Q

How can consumer behavior influence corporate actions?

A

Consumers may avoid products from companies that do not meet ethical standards, pushing companies to adopt better practices.

90
Q

How can doing good also improve a company’s bottom line?

A

For example, capturing and repurposing toxic waste byproducts can turn a liability into a useful resource, improving profitability.

91
Q

Why is the environment a significant consideration in ESG (Environmental, Social, Governance) factors?

A

The environment is significant because companies are increasingly scrutinized on their environmental track record and impact, influencing investment decisions.

92
Q

How can environmental concerns affect a company’s cost of capital?

A

Environmental concerns can lead to higher costs of capital if a company is seen as a polluter, as investors may avoid the company, increasing its cost of funds.

93
Q

What is an example of investor action based on environmental concerns?

A

An example is the Divest Concordia initiative, where investors pushed to liquidate or reduce holdings in fossil fuel-focused companies.

94
Q

What is Socially Responsible Investing (SRI)?

A

Socially Responsible Investing (SRI) involves considering the social consequences of investment decisions and following policies of Equity, Diversity, and Inclusion (EDI).

95
Q

How do SRI firms approach trade?

A

SRI firms pursue equitable or fair trade arrangements, ensuring benefits are shared more equally among consumers, producers, retailers, and intermediaries.

96
Q

What is an example of a fair-trade business?

A

10,000 Villages is an example of a fair-trade business that practices equitable trade.

97
Q

Why is governance important in ESG considerations?

A

Governance is important because it influences how a business is managed, focusing on transparency, minimizing conflicts of interest, and improving business integrity.

98
Q

What does increasing transparency in governance involve?

A

Increasing transparency involves the executive team sharing more about how and why decisions are made within the firm.

99
Q

How can firms minimize conflicts of interest (COI)?

A

Firms can minimize conflicts of interest by having executives recuse themselves from certain votes, disclosing more information, and avoiding business transactions with firms they serve.

100
Q

What role do lobby groups play in governance?

A

Lobby groups can influence fairness and integrity in business operations, and refraining from their use can be seen as an act to improve business governance.

101
Q
A

COMM 221: Financial Markets (8 decks)

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