Midterm #1 Flashcards
Why is a stock valuable?
it is a claim on future payouts to shareholders which are distributed as dividends
Dividends
firms like to keep them steady
can be seen a means of forecasting
Positive NPV
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.
What shows more? Dividends or Earnings?
Earnings because dividends will always be constant for the most part
Cumulative Return
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.
Arithmetic Average
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
Risk free asset
- an asset with a certain rate of return
– Often taken to be short term T-bills
Investment is risky
once we move away from risk free assets due to the uncertainty about future returns
Expected Value (Mean)
The probability-weighted average value across all possible outcomes
ex) lottery being negative return on average
Variance
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
High Variance
means the data points are more spread out
Volatility
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.
Sharpe Ratio
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***
Positive Risk Premium
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
averse
to have a strong dislike towards something
T-Bills
are viewed as a risk free asset
Capital Allocation Line
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.
A higher Sharpe Ratio
indicates a higher CAL meaning the risky asset provides more return per unit of risk
Sharpe Ratio in connection with the CAL
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).
Indexing is a what type of strategy?
Passive strategy
is an investment strategy that seeks to replicate the performance of a specific financial market index, such as the S&P 500
Covariance and correlation
always have the same sign
Covariance
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.
Diversification benefits
increase when asset correlations decrease, especially when correlations are negative.
Diversification
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.
Correlation
ranges form -1 to 1
Stock A and B example with correlation
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.
Standard Deviation
measures the volatility of returns, or how much the returns deviate from the expected return
Risk Aversion
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).
Arithmetic Average Key Points
gives a simple measure of return but doesn’t account for compounding over multiple periods.
HPR can
include both capital gains and dividends
Negative Correlation
can always reduce the overall risk of the portfolio
r^c
return on the combined portfolio
Beta
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
Alpha
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
Diversification and Risk
Diversification reduces the overall risk of the portfolio without reducing the expected return
Higher Sharpe Ratio
More return for the risk taken: A higher Sharpe ratio means the portfolio delivers more excess return
Does leverage diversify a portfolio?
No
Leverage and Sharpe Ratio
Leverage does not change the Sharpe ratio of a portfolio.
Leverage EX)
have 100k use leverage to get an additional 50k
Why do investors use leverage?
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
Minimum variance portfolio
minimizes risk
What portfolio maximizes the Sharpe ratio?
optimal risk portfolio
