Midterm #1

Question 1

Why is a stock valuable?

Answer 1

it is a claim on future payouts to shareholders which are distributed as dividends

Question 2

Dividends

Answer 2

firms like to keep them steady

can be seen a means of forecasting

Question 2

Positive NPV

Answer 2

indicates that an investment or project is expected to generate more value than its cost, after accounting for the time value of money. In other words, a positive NPV means that the present value of the future cash flows from an investment exceeds the initial investment cost, which suggests that the project or investment is profitable and worth pursuing.

Question 2

What shows more? Dividends or Earnings?

Answer 2

Earnings because dividends will always be constant for the most part

Question 3

Cumulative Return

Answer 3

measures the total percentage increase or decrease in an investment’s value over a specified period. It shows how much the investment has grown (or shrunk) from the initial amount to the end value, without breaking it down into annual or periodic increments.

Question 4

Arithmetic Average

Answer 4

This is the simple mean of the returns over a specific period. It is calculated by summing up all the periodic (e.g., yearly) returns and then dividing by the number of periods.

used to sum the overall performance

Question 4

Risk free asset

Answer 4

• an asset with a certain rate of return

– Often taken to be short term T-bills

Question 5

Investment is risky

Answer 5

once we move away from risk free assets due to the uncertainty about future returns

Question 6

Expected Value (Mean)

Answer 6

The probability-weighted average value across all possible outcomes

ex) lottery being negative return on average

Question 7

Variance

Answer 7

is a measure of the spread or dispersion of a set of data points around the mean (average). It quantifies how much the individual data points in a dataset differ from the mean

Question 8

High Variance

Answer 8

means the data points are more spread out

Question 9

Volatility

Answer 9

It is typically measured by the standard deviation or variance of the asset’s returns.

High volatility means prices fluctuate significantly, while low volatility means prices move slowly or remain steady.

Question 9

Sharpe Ratio

Answer 9

a valid statistic for ranking portfolios

not valid for ranking individual assets

It measures the risk-adjusted return of an investment and determines the slope of the CAL***

Question 10

Positive Risk Premium

Answer 10

refers to the additional return that an investor expects to receive, or actually receives, from an investment that carries more risk compared to a risk-free asset. It represents the compensation investors demand for taking on higher uncertainty or volatility when investing in risky assets like stocks, corporate bonds, or real estate, rather than risk-free assets like government bonds

Question 10

averse

Answer 10

to have a strong dislike towards something

Question 11

T-Bills

Answer 11

are viewed as a risk free asset

Question 12

Capital Allocation Line

Answer 12

represents all possible combinations of risk

The slope of CAL equals the increase in the expected return of the
complete portfolio per unit of additional standard deviation.

Question 13

A higher Sharpe Ratio

Answer 13

indicates a higher CAL meaning the risky asset provides more return per unit of risk

Question 14

Sharpe Ratio in connection with the CAL

Answer 14

The Sharpe Ratio allows investors to compare different investments on a risk-adjusted basis. A higher Sharpe Ratio implies that for every unit of risk taken, the investor earns more excess return (above the risk-free rate).

Question 15

Indexing is a what type of strategy?

Answer 15

Passive strategy

is an investment strategy that seeks to replicate the performance of a specific financial market index, such as the S&P 500

Question 15

Covariance and correlation

Answer 15

always have the same sign

Question 16

Covariance

Answer 16

measures how two assets move together. If it’s positive, the assets tend to increase or decrease together. If negative, one increases while the other decreases.

Question 16

Diversification benefits

Answer 16

increase when asset correlations decrease, especially when correlations are negative.

Question 16

Diversification

Answer 16

is the practice of combining assets to reduce the overall risk.

Diversification works best when asset returns are not perfectly correlated, as this reduces overall portfolio volatility.

Question 16

Correlation

Answer 16

ranges form -1 to 1

Question 16

Stock A and B example with correlation

Answer 16

If you have two stocks, A and B, with a correlation of -0.3, adding them to the same portfolio will reduce overall risk more effectively than two stocks with a correlation of +0.8.

Question 17

Standard Deviation

Answer 17

measures the volatility of returns, or how much the returns deviate from the expected return

Question 18

Risk Aversion

Answer 18

measures an investor’s reluctance to accept risk. The more risk-averse an investor, the more they allocate to safe assets (e.g., T-bills) and the less to risky assets (e.g., stocks).

Question 19

Arithmetic Average Key Points

Answer 19

gives a simple measure of return but doesn’t account for compounding over multiple periods.

Question 20

HPR can

Answer 20

include both capital gains and dividends

Question 21

Negative Correlation

Answer 21

can always reduce the overall risk of the portfolio

Question 22

r^c

Answer 22

return on the combined portfolio

Question 23

Beta

Answer 23

measures the systematic risk or market risk of an asset or portfolio relative to the overall market.

It indicates how sensitive an asset’s returns are to movements in the market.

1- moves with the market

negative Beta = moves in the opposite direction

Question 24

Alpha

Answer 24

measures the excess return or abnormal return of an asset or portfolio relative to what would be predicted by CAPM or a market benchmark.
It shows the active return generated by a manager or strategy above the market return, adjusting for risk.

Alpha = 0 = in line with the expected return based on the risk

Question 25

Diversification and Risk

Answer 25

Diversification reduces the overall risk of the portfolio without reducing the expected return

Question 26

Higher Sharpe Ratio

Answer 26

More return for the risk taken: A higher Sharpe ratio means the portfolio delivers more excess return

Question 27

Does leverage diversify a portfolio?

Answer 27

No

Question 28

Leverage and Sharpe Ratio

Answer 28

Leverage does not change the Sharpe ratio of a portfolio.

Question 29

Leverage EX)

Answer 29

have 100k use leverage to get an additional 50k

Question 30

Why do investors use leverage?

Answer 30

Investors use leverage to increase their exposure to the risky asset beyond what their initial capital allows. By borrowing at the risk-free rate, they can take a larger position in the risky asset and achieve a higher expected return.

ABLE TO MAXIMIZE UTILITY

Question 31

Minimum variance portfolio

Answer 31

minimizes risk

Question 32

What portfolio maximizes the Sharpe ratio?

Answer 32

optimal risk portfolio