PoF Flashcards
Arbitragers
Trading the same asset in 2 different markets, where they are 2 different prices. Buying cheap, in one market, and selling same asset at a higher price is another marker. (Zero Risk)
Speculator
Has no pre-existing exposure to the underlying asset, but have belief about where the price of the asset is going. (Taking on risk)
Hedger
Has existing exposure to an underlying security (or product) and wishes to minimise or eliminate this exposure.
Capital market line
The CML can only be used to price “efficient” portfolios.
The CML assumes portfolios are fully-diversified and efficient with zero systematic risk.
It can not be used to price individual securities bc they’re not efficient and will always have some unsystematic (diversifiable) risk.
Beta relationships
Beta = 1 - the security has the same systematic risk as the market portfolio.
Beta = 0 - Security has zero systematic risk.
Beta > 1 - security has higher systematic risk than the market portfolio
Beta < 1 - security has lower systematic risk than the market portfolio.
If the correlation efficient, rho, is zero, beta is equal to 0.
accounting rate of return
average earnings (EBIT) / initial investment x 100.
Decision rules -> a project is acceptable if its ARR exceeds a pre-specified minimum rate of return. For exclusive projects the project with the highest ARR is preferred.
payback period
a projects payback period is the time it takes for the initial cash outlay on a project to be recovered from the net after-tax cash flows.
Decision rules:
a project is acceptable if its payback period is less than a pre-specified maximum payback period. for ME projects, the project with the shortest payback period is preferred.
problems with accounting rate of return
earnings are not net cash flows.
- earnings numbers are subject to the vagaries of the accounting choices made by managers.
the time value of money is ignored.
- a dollar of earnings tomorrow is regarded as equivalent to a dollar of earnings today.
problems with payback period
the payback period method fails to take into account of the cash flows that occur after the payback period cut-off date.
- its biased against projects that have longer development periods. e.g. mining and exploration projects.
it ignore the time value of money.
problems with incremental IRR
The incremental IRR may not exist.
Multiple incremental IRRs can exist.
The fact that the IRR exceeds the required rate of return for both projects doesn’t necessarily imply that either project has a positive NPV.
The individual projects may have different required rates of return.
delayed investments
situations where net cash outflows follow net cash inflows.
we receive cash up front and have to spend money in the future.
NPV of project increases w discount rate employed
business (operational risk)
the variability of future cash flows attributed to the nature of the firms operations.
Its the risk faced by shareholders if the firm were financed only by equity.
Business risk is reflected in the variability on the return on assets.
financial risk
increase in the variability in the returns to shareholders is financial risk, as a consequence of introducing debt into the firms capital structure (leverage)
beta
measures systematic risk
return correlation relationships
the correlation coefficient, rho, tells us how closely related the movements of the two assets are.
rho = +1 , perfect positive correlation (if one asset in the portfolio goes up/down the other does the same thing)
rho = -1 , perfect negative correlation (when one goes up/down the other does the opposite)
rho = 0 , there is no correlation between the movements)
rho = -1 < x < +1 , general case.
When assets are perfectly correlated, there is no diversification benefit as they move identically. As correlation decreases, diversification benefits increase.
You dont need a negative correlation coefficient to have diversificaiton benefit. Anytime rho is less than one, the risk of your porfolio will be lower than the weighted average risk of the assets in the portfolio (i.e. you have a diversificaiton benefit)