Midterm 3 Part 1 Flashcards
What is Return - Risk Free Rate?
Actual Return or Adjusted Return
What is the risk free rate?
It’s a theoretical rate that you would get if there was absolutely no risk.
It represents what the investor would expect to get if there was no risk involved.
Why is the risk free rate theoretical?
Because it’s impossible to have an investment with absolutely no risk.
How is the risk free rate calculated?
It’s usually the interest rate of a 3 month U.S. treasury bill (because it’s very unlikely that the U.S. will default on its bonds).
Why is the risk free rate important?
Because it is the baseline for banks and corporations in setting their own interest rates.
For example, they start with the risk free rate and then add additional interest depending on the risks involved with that type of investment.
True or False: The risk free rate is the minimum return an investor expects to get.
True
Should you invest your money if the potential rate of return is less than the risk free rate?
NO! If the potential/expected rate of return is less than the risk free rate, it means you are getting less than the bare minimum return.
What is absolute risk?
The risk of making a loss on an investment.
It’s the probability that something will go wrong.
What is relative risk?
It is the comparison of risk on some investment to a common standard of risk, in the U.S. stock market, that standard is the S&P 500
What is default risk?
The risk that the investment will default and will not be able to pay you back (like of the company defaulted, or in the case of the U.S. treasury bond, if the U.S. couldn’t pay their debts).
What is this:
σ
The sign for standard deviation or the volatility of an investment.
Basically, this is the “risk” of the investment.
What is the Sharpe Ratio formula:
σ
In the Sharpe ratio, is it better to have a small or large denominator compared to its numerator?
Better to have a small denominator compared to the numerator. This means that there is relatively little risk and the returns are high.
True or False: The higher the Sharpe ratio is, the better.
True
True or False: The Sharpe ratio is best applied to stocks/investments that are different.
FALSE.
It works best when you’re comparing things that are similar.
How would you define risk?
It is uncertainty about the market. It could mean something bad will happen, but it could also mean something GOOD will happen.
That’s why risk is often compared to volatility, because it fluctuates, rather than just going straight down.
IT IS THE POSSIBILITY THAT THE ACTUAL RETURN WILL DIFFER FROM THE EXPECTED RETURN.
Downside risk
The chance of something bad happening
Upside risk
The chance of something good happening
What does the risk appetite mean?
It is referring to the three components to consider when deciding if you want to invest in something. Like how “hungry” are you to invest in that specific thing?
It weighs your needs, your ability, and your willingness to make the investment (usually determined by risk)
True or False: It’s better to pull out of the market when it’s fluctuating a lot.
False.
Riding it out usually gets you the best returns.
Is return usually written as an annualized percentage?
YES!
Returns are measured in an annual period by default.
Holding Period
The length of time you hold an asset before selling it
Annualized return
It is the return rate calculated for the YEAR, rather than just the holding period.
Historical data
Past prices and cash flows. It is often used to forecast.
Expectational data
Our best guess or estimate of future cash flows and prices, based on a hypothesized state of the world.
Nominal rate
The interest rate without considering inflation.
True or False: Volatility is a measure of TOTAL risk.
True
What two parts make up TOTAL risk?
Systematic and unsystematic
What is unsystematic risk?
It is firm-specific risk, and doesn’t apply to the whole market, just that company.
What is systematic risk?
Risk that has to do with the overall economy.
What’s another name for systematic risk?
Market risk
How do you get rid of unsystematic risk?
You diversify your portfolio and make it larger.
The more assets you have in your portfolio, the better that risk will average out.
Diversification
The averaging out of firm-specific risk as you invest in many different types of assets.
Because even if something bad happens to one firm, something really good may happen to another.
Diversifiable risk
Firm-specific risk, unsystematic risk
What happens as you diversify your portfolio and minimize unsystematic risk?
The volatility or standard deviation is going to go down.
What does standard deviation measure?
The total disparity between the ups and the downs of an asset’s volatility. Just think of the graph on youtube. The larger the gap between the highest high and the lowest low, the larger the standard deviation.
The goal is to make it as small as possible.
True or False: The greater the standard deviation, the greater the uncertainty; and the greater the uncertainty, the greater the total risk.
True
True or False: For a standard deviation mean of +1/-1, we expect to see about 68% of returns fall into those ranges.
True
What percentage of returns will fall into the +2/-2 range of standard deviation?
95% on a regular graph
What percentage of returns will fall into the +3/-3 range of standard deviation?
99.7% on a regular graph
Does standard deviation measure systematic or unsystematic risk?
WRONG, trick question, it can only measure TOTAL risk.
What is the relationship between risk and return?
It is positive. Greater risk = greater return
What are the three most common market risk factors?
- Interest rate changes
- Tax changes that create unexpected cash flows
- Business cycle changes
What are three examples of firm-specific risk?
- A company’s labor force goes on strike
- change in company management
- Oil tank bursts and floods a company’s production area
True or False: You can diversify systematic risk away.
False
What is the prime driver of systematic risk?
Business cycle risks
Correlation
How assets are related to other assets, how they move together.
Perfect Positive Correlation
Assets move perfectly in tandem.
Also called +1
Perfect Negative Correlation
Assets move directly opposite each other.
-1
Imperfect Positive Correlation
The assets move together, but not at +1, less than +1
True or False: If two assets are perfectly positively correlated, they don’t help to diversify your portfolio.
True. If they’re doing the same thing, they can’t average each other out to zero.
True or False: If we add two assets to our portfolio that are perfectly negatively correlated, we can eliminate all risk.
TRUE. Because they cancel each other out.
True or False: It’s hard to find assets that are perfectly at -1, and usually you’re just trying to get your portfolio as close to that as possible.
True.
Most are in the .3 to .4 range
True or False: Lower correlation means greater diversification and less risk.
TRUE
True or False: Diversifying a small portfolio, with only a few assets, greatly reduces risk.
True!
True or False: Diversifying a large portfolio with many assets, greatly reduces risk.
False.
The more assets you have, the less of an impact you get by buying more and more assets.
The risk doesn’t decrease as quickly when you already have a very diversified portfolio.
Why does a graph of eliminating risk through diversification eventually level out and become horizontal?
Because you’ve diversified away all of the unsystematic risk, but you cannot get rid of the systematic market risk.
Systematic Risk Principle
It is the market risk that matters when making decisions about investing, because that’s the risk you have to take on (you can’t diversify it away).
The size of the risk premium is based on market risk (beta)
True or False: The number of assets you buy is more successful at diversifying away risk than the negative correlations of those assets.
FALSE.
If you have fewer assets, but they’re all in different industries, you’ll likely reduce more risk than if you bought a bunch of assets from the same industry.
What is another name for Beta risk?
Systematic risk.
Beta measures systematic risk.
Beta
The risk that is inherent in the market. It cannot be diversified away.
Used to measure the inherent systematic risk in a company.
What’s an example of a company with high Beta?
Apple. It is a luxury company. When the market does well, they do well. When the market falls, they fall.
What is an example of a company with low Beta?
Utility companies. Regardless of how the market is doing, people are going to keep paying for utilities regularly
True or False: Different firms have different levels of systematic risk.
TRUE!
Even though the market affects all companies, they differ in how much they rise and fall with the market.
True or False: Beta is just an average that best describes the correlation between some company compared to “the market”
True.
It’s just the slope of the line that best matches the dots on the graph.
What is the Beta of the Market?
1
What does it mean if you have a beta of 1.2 and the market increases by 10%? How much will your shares go up?
10% x 1.2 = 12%
What does it mean to have a Beta that is higher than the market beta?
It means the company is more volatile than the market. It fluctuates more dramatically when the market changes.
What does it mean to have a Beta that is lower than the market beta?
It means it less volatile and less risky. It fluctuates less dramatically and is considered to be more stable.
Aggressive assets
Companies with betas higher than 1
Defensive assets
Companies with betas less than 1
True or False: Low beta assets are less affected by market crashes
TRUE
What is the beta of cash?
0
True or False: Standard deviation measures total risk
TRUE
True or False: Beta measures total risk
FALSE
It only measures systematic risk
What does CAPM stand for?
Capital Asset Pricing Model
Another name for Required Rate of Return
Return on Equity
What is the RRR?
It is the return rate that is REQUIRED by investors for assuming that level of risk.
What does the risk free rate represent?
Compensation for the time that the investor is without their money.
What is the risk premium?
It is the extra compensation required to take on risk.
For example, if you loan money to the government for 4%, you would loan money to another company for more than that, say 6%. That extra 2% is the risk premium. It’s the extra “fee” essentially for taking on higher risk than the risk free rate.
What factor do we use to calculate risk premium, and why?
THE BETA
Because the unsystematic risk can be diversified away, and the beta measures the rest of the risk.
What does SML stand for?
Security Market Line
What is the slope of the SML?
The market risk premium
What is the point of the SML?
It tells us the reward that investors should expect to receive for bearing different levels of risk (beta)
What is the beta of the risk free rate?
0
What does CAPM measure?
The relationship between risk and return. Specifically, it gives us a way to price risk.
Small-firm effect
The CAPM isn’t perfect and has trouble accurately pricing the return on a small firm. It suggests that the small firms will earn less than they usually do.
What does it mean that CAPM is an equilibrium model?
It means that in a perfect world, all businesses would meet the expected rates of return that are predicted on the CAPM model (the SML line)
What can the CAPM be used for in a situation when the world is not in equilibrium?
It can be used to determine if an asset is over or under priced.
What does it mean if an asset lies above the line on the SML?
It is underpriced
What does it mean if an asset is plotted below the line on the SML?
It is overpriced, the business is not offering enough return for the amount of risk you are taking on.
What are the two methods that can determine if an asset isn’t priced correctly based on the CAPM?
- You can discount the FV back to the PV using the return that you calculated from the CAPM.
- You can calculate the annualized return rate and compare that rate with the return you calculated from CAPM.
The method you use will be determined by what information you have available.
True or False: If the offered return rate is less than the RRR, the stock is overvalued.
True
True or False: If the Beta is 1, the returns should equal the market rate of return?
True
Why is the CAPM not a good model for young entrepreneurs?
Because the CAPM assumes that you can diversify away all firm-specific risk. But if you can’t do that, then you’ve got to calculate your returns another way.
What is an alternative method to calculating risk, other than the CAPM?
The Build Up method
True or False: Small businesses typically use the CAPM
FALSE
They use the build up method because they are typically unable to diversify away all firm risk
How does the buildup method work?
You essentially “build up” the RRR or cost of equity by adding together various risk premiums.
What do you get if you add the bond yield plus the equity risk premium?
The CAPM equivalent for a large company with a Beta of 1
What do you get if you add the bond yield plus equity risk premium plus micro cap premium?
The CAPM equivalent for a smaller company with a Beta of 1
What do you get if you add the bond yield plus equity risk premium plus micro cap premium plus startup risk premium?
The CAPM equivalent for a startup company with a Beta of 1
True or False: When using the buildup method, you have to add more premiums if the company is smaller
True.
The smaller the company, the more risk it has
Base Equity rate
The sum of the bond yield and equity risk premium
Micro Cap Equity rate
The sum of the base equity rate and the micro cap premium
Is the buildup method accurate?
It’s a “crude” approximation, but it’s your best bet if you’re trying to value a private firm or startup firm (the type of firms that don’t have historical data you can rely on)
What does CML stand for?
Capital market line
What’s another name for SML?
CML
What does OLS stand for?
Ordering least squares
True or False: Risk premium is asset specific
TRUE
Because Beta changes per asset. Everything else (Rm and Rf) should be the same for all assets.
Is the CAPM a single asset pricing model or multiple asset pricing model?
SINGLE
