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Business Finance > Module 10: Risk, Return, and Market Efficiency > Flashcards

Module 10: Risk, Return, and Market Efficiency Flashcards

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1
Q

What are the 2 things to keep in mind when talking about risk?

A
  1. There’s a reward for bearing risk
  2. The greater the risk, the greater the potential reward (return)
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2
Q

T or F: You cannot earn a return on something that does not have risk.

A

False; you can, although if you want to earn a higher return, you have to take on risk.

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3
Q

What determines the required return on an investment?

A

We want to think about how much RISK is involved

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4
Q

What are the 2 ways for equity holders to get a return?

A
  1. Dividends (money paid from the company back to the shareholders)
  2. Capital Gains
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5
Q

What are the 2 ways Capital Gains are sometimes differentiated?

A
  1. Realized Capital Gains
  2. Unrealized Capital Gains
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6
Q

Match the following two descriptions to whether it describes Realized or Unrealized Capital Gains:
a. means that the price has gone up, but we haven’t collected it.
b. when we sell the stock, then we get that cash if we sold it for more than we bought it for

A

a. unrealized
b. realized (we have now realized those capital gains when we get that cash)

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7
Q

What is the downside to Unrealized Capital Gains?

What is the upside to Unrealized Capital Gains?

A
  • Downside: as long as you still own the stock, yes the price has gone up so far but it can go back down (that risk component). So, until you realize those capital gains, they are paper gains. You could get them right now, but stocks will sometimes fall very quickly. So, the longer you wait, the bigger the chance something happens and those gains can evaporate and even turn into losses.
  • Upside: you can access them at any time, assuming the stock doesn’t go back down, and until you realize them, you don’t pay taxes on them (the longer you can push out those taxes, the less it costs).
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8
Q

What is one of the big reasons why share buybacks are becoming more common than dividends?

A

Bc share buybacks, which pushes more of the returns of stocks to the capital gains side, which offers tax efficiency.

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9
Q
  • What is the formula for calculating overall return for equity holders?
  • What part of the formula is the “Capital Gains” portion?
  • What part of the formula is the “Initial Investment” portion?
A
  • Overall Return = ((Ending Price - Beginning Price) + Dividends) / Beginning Price
  • Capital Gains Portion: (Ending Price - Beginning Price)
  • Initial Investment Portion: Beginning Price (in the denominator)
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10
Q

What is the formula for calculating overall return for bondholders?

A

Overall Return = ((Ending Price - Beginning Price) + Coupon) / Beginning Price

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11
Q

What is the big difference between the Overall Return for Equity holders and Bondholders?

A

Ending Price for bondholders could be what we sell it for (if we sell the bond before it matures), or it could be the par value (if we hold it until maturity).
Whereas with stock, there isn’t an ending price, bc we can potentially hold it for forever.

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12
Q

When calculating Percentage Return, you divide the answer from Per Share Dollar Return or Total Dollar Return / (Initial/Ending) Cost.

A

Divide by INITIAL cost

(doesn’t matter if you use the answer from per share dollar return or total dollar return)
^ if you use total dollar return make sure to use initial cost in terms of total initial cost.

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13
Q

We cannot have a negative dividend, so they will always be ________ or _____, but the price can either go up from what we bought it at or it can go down, which is why we would typically get a (higher/lower) return on stocks in the long run because we are taking that risk, but if we have to sell before the long run, we’re going to take a _____.

A

positive; 0; higher; loss

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14
Q

the excess required from an investment in a risky asset over that required from a risk-free asset.

A

risk premium

(Long-term corporate bonds have a risk premium over long-term government bonds (bc the government won’t default since they can print money).

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15
Q

T or F: You can get a higher average return when you take on more risk, particularly over a long period of time.

A

True

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16
Q

Which is the riskiest type of asset, which therefore will earn you the highest return and risk premium?
a. large company stocks
b. small company stocks
c. long-term corporate bonds
d. long-term government bonds
e. U.S. Treasury Bills

A

b. small company stocks

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17
Q

If small company stocks average return was 16.3% and U.S. treasury bills return was the most risk-free asset, earning an average return of 3.4%, how would you calculate risk premium for small company stocks?

A

16.3 - 3.4 = 12.9%

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18
Q

Which is the most risk-free asset, therefore having the lowest risk premium and lowest average return?
a. large company stocks
b. small company stocks
c. long-term corporate bonds
d. U.S. Treasury Bills
e. long-term government bonds

A

d. U.S. Treasury Bills

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19
Q

Why is there additional risk with long-term government bonds compared to to U.S treasury bills even though they both have no default risk? (2 things)

A
  • There is less liquidity and more interest rate risk with long-term government bonds
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20
Q

T or F: All risk is the same

A

False; there are different types of risk

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21
Q

What are the 2 types of risk?
Which type gets rewarded if the market is efficient and which risk does not get rewarded?

A
  1. Nondiversifiable risk (systematic risk) – gets rewarded
  2. Diversifiable risk (unsystematic risk) – doesn’t get rewarded
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22
Q

a risk that influences a large number of assets

A

nondiversifiable risk

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23
Q

Nondiversifiable risk is also referred to as _________ risk or ________ risk.

A

systematic; market

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24
Q

Which type of risk is this an example of:
things like wars, presidential elections, and big economic effects like recessions are events that will cause most assets to go up or down at the same time, and it doesn’t matter if you own 1,10,or 100 stocks– if it’s a bad day for the market, your portfolio is almost certainly going to do poorly (and vice versa) regardless of how many assets you own.

A

nondiversifiable (systematic/market) risk

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25
Q

a risk that affects at most a small number of assets.

A

diversifiable risk

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26
Q

Diversifiable risk is also referred to as ________ risk or ________ ________ risk.

A

unsystematic; asset-specific

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27
Q

What type of risk is this an example of:
if the justice department decides to break up Google

A

diversifiable risk

(This is potentially a bad thing if you’re a Google shareholder, but if instead of owning Google, you own S&P 500, well, Google is a part of S&P 500 and this news will hurt Google, but it probably also helps some of their competitors like Microsoft and most of the market isn’t affected one way or the other. (like, Mcdonald’s stock probably doesn’t matter if Google is one company or broken up into 4 companies).

28
Q

It is riskier to own Google stock vs. the S&P 500, but you won’t necessarily get rewarded for that extra risk because it’s so easy to get rid of, just by holding 30 stocks instead of a single 1 stock, you can get rid of almost all of that _________ risk.

A

diversifiable

29
Q

spreading an investment across a number of assets will eliminate some, but not all of the risk. This is the _________ _____ _________.

A

Principle of Diversification

30
Q

Unsystematic risk is essentially eliminated by _________, so a portfolio with many assets has almost no unsystematic risk.

A

diversification

31
Q

The expected return on an asset depends on the asset’s (diversifiable/nondiversifiable) risk.

A

nondiversifiable (systematic)

32
Q

How do we measure systematic/nondiversifiable risk?

A

Beta

33
Q

the amount of systematic risk present in a particular risky asset relative to the market portfolio

A

Beta Coefficient (β)

(which has a beta of 1)

34
Q

To calculate beta (which we won’t be doing in class, but to understand it):
- On x-axis, we have ______ ______.
- On y-axis we have _____ ______ _____.
- Then, we just pick a month, day, or year and plot the market return and our asset return for those months/days/years. Then over time, we get a line. And that _____ of the line is our beta.

A
  • market return
  • our asset return
  • slope
35
Q

If how the market is doing doesn’t affect the return on our asset at all, we would have a Beta of _____, aka no ________ risk.

A

0; systematic

36
Q

T or F: In general, most stocks are going to have a measured Beta that’s very close to one.

A

True

37
Q

An equilibrium asset pricing model showing that the expected return for a particular asset depends on the pure time value of money plus a reward for bearing systematic risk.

A

The Capital Asset Pricing Model (CAPM)

38
Q

The most common way of estimating the expected return for a stock in particular is by using ________.

A

CAPM (Capital Asset Pricing Model)

39
Q

What CAPM says is that _____ is what matters for our assets’ return.
So, if we want to know the expected return for an individual asset, we’ve got 3 basic components that we need:

A
  • beta
    1. Rf – (our risk-free)
    2. Bi – (our beta)
    3. (Rm - Rf) (the return on the market - the risk free) – (this is the market risk premium)
40
Q

What is the formula for calculating our expected return on an individual asset using the CAPM Model?

A

Ri = Rf + Bi x (Rm- Rf)

That is Ri = Risk free + Beta x (Market Risk Premium)

41
Q

Match the descriptions given to which basic component that we need for the CAPM model:
a. how much risk our asset has
b. the return we get for foregoing consumption today. There is no risk involved in it.
c. how much extra return we need to get per unit of risk we’re taking on.

A

a. beta
b. risk-free
c. market risk premium

42
Q

In principle/practice, if we are using the CAPM model for real assets:
- the risk free is usually going to be some form of _______ _______.
- Beta is going to be estimated using _______ ______ (downside to this is it’s measuring how much risk there was in the past, so this only works well if the company’s risk profile is _______ _______).
- The market risk premium typically gets estimated using _______ ______, but this is fairly sensitive to what ______ _______ we look at and things like that.

T or F: All of these things are going to be estimates, but once we have the numbers in there, we now have a way to estimate the return to our asset.

A
  • treasury security
  • historical data; relatively stable
  • historical data; time period
    -True
43
Q

A graphical representation of the Capital Asset Pricing Model (CAPM)

A

Security Market Line

44
Q

T or F: If markets are efficient, and the CAPM model is true, we should expect to see that every security is going to fall somewhere on the security market line.

A

True

45
Q

In regards to the Security Market Line:
- Our x-axis will be our _____, and our y-axis is the ______ ______.
- Down at the bottom of the y-axis will be our _____ _____ rate. In the middle of the y-axis will be our _____ _____ to the _______.
- So, if we fit a line through that, the gap on the y-axis is our _____ _____ ______.
- In the middle of the x-axis we have a beta of one. From 0-1, this is the _____ of the ______.

A
  • beta; expected return
  • risk-free; expected return; market
  • market risk premium
  • risk; market
46
Q

On the Security Market Line, if we have an asset that is an outlier (not on the line), what does this mean if:
1. it’s above the line?
2. it’s below the line?

The gap between the outlier and the line is what’s called ______.

A
  1. above = has a higher return than it should
  2. below = has a lower return than it should
  • alpha
47
Q

the extra or less return (negative _____) that cannot be explained by the risk factor.

A

alpha

48
Q

If markets are _______, then there will be some assets that are above the security market line and some that are below. So, if we can just buy the assets that are (above/below) the line, we will get more return than we should after controlling for that risk.

If markets are efficient, then that means that either the gaps won’t be there/they will be very ______, or the gaps are just hard to ______.

A
  • inefficient; above
  • small; identify
49
Q

T or F: For CAPM problems, if we’re given the expected return on the market, we plug this directly into our CAPM formula.

A

FALSE; use this to calculate our market risk premium, then plug THAT into the problem

50
Q

T or F: For CAPM problems, we need to add percentage signs.

A

False; we DON’T

51
Q

_________ ________ ________ is a theory that states that prices reflect available information. (it doesn’t mean that prices are correct and won’t change, but that those changes will happen as new information comes in)

This means there is no ______ ______ from trading on information!

A

Efficient Market Hypothesis; excess profits

52
Q

T or F: According to the Efficient Marketing Hypothesis, there’s no way to predict whether the next bit of information that comes in is going to be good or bad, so there is no way to predict which stock is going to outperform.

A

True

53
Q

Markets can vary in how efficient they are. What are the three main types/levels of market efficiency?

A
  1. Weak form efficiency
  2. Semi strong form efficiency
  3. Strong form efficiency
54
Q

Which type of market efficiency does this describe:
past price information is already reflected in the price.

A

weak form efficiency

(You can’t just look at what’s been happening to the price over the last 10 days or something and tell whether the price is going to go up or down moving forward.)

55
Q

If markets are weak-form efficient, then this means you can’t really add value or gain any excess return through _______ _______.

A

technical analysis

56
Q

looking at charts of past prices and looking for signals in the prices to whether something is a buy or sell opportunity.

A

technical analysis (sometimes called charting)

57
Q

Which type of market efficiency does this describe:
public information is already reflected in the price.

A

semi strong form efficiency

(Anything that you can read in the company’s financial reports is going to already be reflected in the market)

58
Q

If markets have semi strong form efficiency, then you can’t earn an excess return through ________ ________. It is already reflected in the current price.

A

fundamental analysis (you can’t earn anything extra from analyzing a company’s financial statements or anything that’s publicly known)

59
Q

Which type of market efficiency does this describe:
private information is already incorporated in the price.

A

strong form analysis

60
Q

Strong form efficiency markets say you can’t earn an excess return even with _______ ________.

A

insider trading (someone from the company gives you info not publicly known)

61
Q

T or F: Most of the time, insider trading is illegal.

A

True

62
Q

T or F: Intuitively, how efficient markets are depends on how many people there are trading and gathering information about companies.

A

True

63
Q

T or F: For individual investors, the market is going to be pretty efficient.

A

True

(bc you probably aren’t going to be able to devote 80 hours a week to analyzing companies and you’re not going to have the insider access that analysts have to these things)

64
Q

What should you do if markets are efficient?

A

Index funds! (better off saving that fee; not trying to outperform, just want to passively collect returns given whatever level of risk we’re comfortable with)

65
Q

T or F: If markets are less efficient, you should index funds.

A

False; you are better off going with the active managers and paying that fee.

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