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CFA Level II Equities > Reading 31 - Return Concepts > Flashcards

Reading 31 - Return Concepts Flashcards

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CFA flashcards
1
Q

How do you caluclate a Holding per Return (HPR))?

A
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2
Q

If a daily return is 0.80%, how would you calculate an annualized return?

A

= (1.0008) ^365

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3
Q

Define the required rate of return…

A

The minimum level of expected return that an investor requires in order to invest.

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4
Q

How do you calculate Expected Alpha?

A

= Expected Return - Required Return

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5
Q

If an asset’s price equals the intrinsic value price, what is the expected alpha?

A

0

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6
Q

How do you calculate an expected return?

A

= Required return + a return from the convergence of price to value

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7
Q

What does Market Informational Efficiency mean?

A

Price is equal to current intrinsic value

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8
Q

Define the Equity Risk Premium….

A

The incremental return that investors require for holding equtiies rather than the risk free asset

Equity Risk Premium = required return on equity index - risk free rate

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9
Q

What are the steps to create a historical Equity Risk Premium estimate?

A
  1. Determine which equity index to represent market returns
  2. Chose the time period for computing the estimate
  3. Calculate the mean return on the index
  4. Select a proxy for the risk free rate
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10
Q

When estimating an Equity Risk Premium, explain when Arthimetic Mean and Geometric Mean are most appropriately used

A
  • Arithmetic - when looking at a single period
  • Geometric - the preferred method for use in historical estimates
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11
Q

Explain Survivorship Bias….

A

tends to inflate historical estimates of ERP because poorly performing or defunct companies have been removed from the index

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12
Q

How do you calculate the Gordon Growth Model (GGM) equity risk premium?

A

= (1 yr forecasted dividend yield on market index) + (consensus long term earnings growth rate) - (long term government bond yield)

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13
Q

What are two weakness of the GGM ?

A
  1. That forward looking estimates will change through time and need to be updated
  2. The assumption of a stable growth rate, which is often not appropriate in rapidly growing economies
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14
Q

What is the formula of the Macroeconomic Model created by Ibotson & Chan?

A
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15
Q

How do you calculate expected inflation (EINFL)?

A

= (1+YTM on 20 yr t-bonds) / (1+ YTM on 20 yr TIPS) - 1

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16
Q

How do you calculate the Expted Growth in Real EPS?

A
  • Should approximately track the real GDP growth rate
  • Real GDP = Σ Labor Productivity Growth + Labor Supply Growth rate
17
Q

How do you calculate the expected growth in the P/E ratio?

A
  • Base value is 0 to reflect the efficient markets view
  • 1.05 would represent a view that the P/E would rise by 5%
18
Q

What are the 2 key assumptions within CAPM?

A
  1. Investors are risk averse
  2. Make investments based on the mean return & variance of returns in their portfolios
19
Q

What is the main insight of the CAPM model?

A

That investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk of their portfolio

20
Q

What is Beta ?

A

The measure of the level of systematic risk assumed from holding the security

21
Q

What are 2 influences on Beta estimates?

A
  1. Choice of index for market portfolio
  2. length of data period and the frequency of observations
22
Q

What is beta drift?

A

the observed tendency of an estimated beta to revert to a value of 1.0 over time

23
Q

What is the formula for Adjusted Beta?

A

= (2/3 * regression beta ) + (1/3 * 1)

24
Q

What time period is the industry standard for calculating betas?

A

5 Years

25
Q

How do you calculate the WACC?

A
26
Q

How is the Fama and French Model different from CAPM?

A

Fama and French is a multi factor model, while CAPM is a single factor model

27
Q

What are the 3 factors within the Fama and French model?

A
  1. RMRF - the return on a market value weighted equity index in excess of the 1 month tbill rate
  2. SMB - small minus big. SMB is the average return of three small cap portfolios minus the average return of on three large cap portfolis. SMB represents a small cap return premium
  3. HML - high minus low. the average return on two high book to market portfolios minus the average return on two low book to market portfolios. HML represents a value return premium.
28
Q

What is the equation for the FAMA and French Model?

A
29
Q

How is the Pastor-Stambaugh Model different than the Fama and French model?

A

It encompass the compensation for the degree of liquidity of an equity investment

30
Q

What is the formula for the Pastor - Stambaugh model?

A
31
Q

What are the factors in the 5 Factor BIRR model?

A
  1. Confidence Risk - if confidence is high, the investor will accept a small reward to switch from gov’t to corporate bonds
  2. Time Horizon Risk - Unanticipated change difference between 20 gov’t bonds and tbills. Reflects investors willingness to invest for the long term
  3. Inflation Risk - Unexpected change in the inflation rate
  4. Business Cycle Risk - unexpected change in the level of real business activity
  5. Market Timing Risk - portion of total return not explained by the 1st 4 factors
32
Q

When are Build Up Method estimates of the required return on equity used?

A

For closely held businesses

33
Q

How is the Build Up Method Estimates of the Required Return of Equity calculated?

A

this methods parallels the risk premium approach embodied in the multi factor model with the difference that specific beta adjustments are not applied to factor risk premiums

34
Q

How can the cost of equity be estimated for companies with publicly traded debt?

A

The Bond Yield Risk Premium

35
Q

How do you calculate the Bond Yield Risk Premium?

A
36
Q

What kind of free cash flow is after more senior claims (ie. promised payments on debt and taxes)?

A

Free cash flow to equity

37
Q

When discounting back free cash flow to equity, what is the appropriate rate to use?

A

The required rate of return of equity

38
Q

What the the appropriate discount rate to use when a cash flow is available to meet the claims of all of a companies capital providers?

A

The firm’s cost of capital

CFA Level II Equities (10 decks)

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