Lecture 5 Equity Valuation and Strategies

Question 1

Equity Strategies

What are the two primary equity strategies?

Answer 1

1. Passive Investment (e.g., Index Funds, buy-and-hold strategies, consistent with Efficient Market Hypothesis).
2. Active Investment (e.g., compensation for information, fundamental and technical analysis, style investing).

Question 2

CAPM revisist

Define the Capital Asset Pricing Model (CAPM) and its key assumption

Answer 2

CAPM suggests that an asset’s risk premium is proportional to its beta and market risk premium

Key Assumptions:
* Homogeneous expectations.
* Short selling allowed.
* Borrowing/lending at the risk-free rate.
* No transaction costs.

Question 3

Asness, Frazzini and Pedersen (2012), Frazzini and Pedersen (2014)

What is the Theory of Leverage Aversion?

Answer 3

• Leverage-constrained investors cannot borrow to invest in safe assets, so they buy risky assets instead.
• This drives risky asset prices up (lowers returns) and safe asset prices down (raises returns).
• Unconstrained investors overweight safe assets, earning a premium for bearing leverage risk.
• Result: A new equilibrium where safe assets offer higher Sharpe ratios.

Question 4

Betting Against Beta

What is the “Betting Against Beta” strategy?

Answer 4

This strategy capitalizes on the disparity in reward-to-risk ratios between low-beta and high-beta stocks. It involves overweighting low-beta (safe) stocks and underweighting high-beta (risky) stocks while maintaining market neutrality.

Question 5

Risk Parity

How does Risk Parity work in portfolio construction?

Answer 5

This strategy diversifies the portfolio by equalizing risk contributions across all assets, instead of equalizing dollar weights. It emphasizes overweighting low-volatility assets and underweighting high-volatility assets.

Tangency Portfolio

Higher returns for not so much more risk and no leverage needed

Question 6

Constanf Growth Model

What is the Constant-Growth DDM?

Answer 6

Assumes dividends grow at a constant rate g

Question 7

Dividend Discount Model

Define the Dividend Discount Model (DDM)

Answer 7

Question 8

What does Present Value of Growth Opportunities (PVGO) indicate?

Answer 8

PVGO measures value from reinvested earnings.

Question 9

Efficient Frontier

Explain the empirical efficient frontier.

Answer 9

Represents historical mean-volatility profiles of U.S. stocks and bonds. Shows tangency and risk-parity portfolios outperforming market portfolios due to optimal diversification and leverage.

Question 10

Liquidity Risk

What are the types of liquidity risk?

Answer 10

1. Market liquidity risk: Rising transaction costs for illiquid stocks.
2. Funding liquidity risk: Risk of cash shortages for trade maintenance.
3. Demand pressure risk: Compensating for selling under buying pressure.

Question 11

Valaution

Describe the “Top-down” and “Bottom-up” valuation approaches

Answer 11

Top-down: Analyze macroeconomics → Select industries → Pick securities.

Bottom-up: Identify undervalued/overvalued stocks using DCF or Relative Valuation.