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FNCE 3302 > Midterm 2 > Flashcards

Midterm 2 Flashcards

Studying for Exam

1
Q

What is Expected Return measured by?

A

by mean (average)

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2
Q

What is Risk measured by?

A

by variance or standard deviation

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3
Q

Unsystematic Risk

A

unique, diversifiable risk, due to each stock’s individual risk (variance)

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4
Q

Systematic Risk

A

market, undiversifiable risk, due to + covariance among stocks (which is due to the business cycle)

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5
Q

Market Portfolio

A

contains all the risky assets in the market, and is diversified to the largest extent (contains 100% market risk)

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6
Q

What is the measure for systematic risk?

A

Beta

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7
Q

What does Beta measure exactly?

A

a stock’s tendency to move together with the market

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8
Q

What does the Capital Allocation Line (CAL) represent?

A

all possible portfolio combinations of the risky asset (A), and the risk-free asset (rf)

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9
Q

What does the CAL’s slope equal to?

A

the sharpe ratios of the portfolios

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10
Q

What does the Sharpe Ratio measure?

A

it measures the excess return for each unit of risk (also called reward-to-variability ratio)

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11
Q

Is choosing a CAL portfolio a technical or preference choice?

A

a technical choice, because you’ll always want a higher sharpe ratio, because it provides a better return with lower risk

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12
Q

the smaller the correlation?

A

the better diversification can be achieved

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13
Q

Minimum Variance Portfolio (MVP) occurs when:

A

correlation = -1 and variance/std. deviation = 0 (no risk)

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14
Q

What does it mean for a portfolio to be dominated?

A

when it’s inefficient compared to another portfolio; same risk but lower expected return

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15
Q

What is the efficient frontier of risky assets?

A

portfolios above the MVP

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16
Q

What is the efficient frontier of risky assets and a risk-free asset?

A

the tangent line (tangent portfolio = optimal risky portfolio)

17
Q

The optimal risky portfolio:

A

has the highest sharpe ratio

18
Q

Two-fund separation by Tobin

A
  1. figure out the tangent portfolio (technical process)
  2. choose a mix of rf and the tangent portfolio depending on risk preference (personal process)
19
Q

Assumptions of CAPM

A
  • perfect capital markets
  • investors are mean-variance optimizers
  • investors have same assets and can borrow at the risk-free rate
  • homogeneous expectations
  • single-period investment horizons
20
Q

Principle Result (conclusion) of CAPM

A
  • the market portfolio is an efficient portfolio
  • given the same efficient frontier, all investors will hold the same tangent portfolio (the market portfolio)
21
Q

What are the two implications of the efficiency of the market portfolio (CAPM)

A
  1. every investor is fully diversified with a mix of the market portfolio and the risk-free asset
  2. as risk (Beta) increases, return increases
22
Q

Capital Market Line (CML)

A

the tangent CAL when the optimal portfolio is the market portfolio

23
Q

Security Market Line (SML)

A

graphically represents the CAPM formula
- plotted in beta/return space
- reflects that only systematic market risk should be priced

24
Q

What’re the 3 applications of CAPM?

A

pricing of non-traded assets, capital budgeting, and performance evaluation

25
Q

What does CAPM provide when pricing non-traded assets?

A

a discount rate to do DCF analysis

26
Q

What does CAPM provide when capital budgeting?

A

the required rate of return, or the hurdle return

27
Q

How to operationalize CAPM?

A
  1. Define a risk-free asset such as T-Bills
  2. Select a market index or benchmark
  3. Derive estimates of asset betas
  4. Use linear regression (Security Characteristic Line)
28
Q

What is the slope of the Security Characteristic Line?

A

Beta

29
Q

What is the intersection of the Security Characteristic Line?

A

Alpha

30
Q

What do perfect capital markets imply?

A

no transaction costs, no taxes, information is symmetric; investors are price takers

31
Q

Covariance =

A

correlation x std. dev. (A) x std. dev. (B)

32
Q

According to CAPM, what will not impact the risk premium that a
particular investor X will require for a particular stock Y?

A

the risk aversion of X

FNCE 3302 (2 decks)

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