Required knowledge Flashcards
Steps to get to full portfolio
1) Efficient frontier - min variance - max return
2) Investors on the frontier based on their risk
3) Introduction of borrowing and lending at risk-free rate
4) Tangency at market portfolio
5) All investors move to the tangency
6) through leveraging and investing money in risk free rate, people move to their optimal point
7) point is based off how risk averse they are
Is A pos or neg for risk averse investor
Positive
assumptions of portfolio theory (3)
Portfolio of N stocks
Efficient set when riskless asset
Market equilibrium
What is the difference between systematic and unsystematic risk
Systematic is macro-economic factors affecting the whole market whereas unsystematic is specific to individual share and can be removed through diversification
What is the CML
The line of all the risky and riskless efficient portfolios
What is the market portfolio
All stocks in the economy with weights equal to market share
CAPM assumptions
No transaction costs
Diversified portfolio
no personal income tax
markets perfectly competitive
homogenous expectations
What is beta
Measure of systematic risk for a stock
What are the two types of beta depending on values
beta less than one is defensive, greater than one is aggressive
Applications of the CAPM
Portfolio selection
mispriced shares
Portfolio performance
Required rate of returns for projects
If a security has an estimated return under the SML is
overpriced
What is the difference between sharpe and treynor
treynor is only systematic risk whereas sharpe is total
Other forms of CAPM
riskless borrowing/lending
varying rates of lending and borrowing
personal taxes
What does the introduction of personal taxes affect
Before hand it implied investors were indifferent to dividends and capital gains, now if their tax bracket is below aer, they should have higher dividend
Empirical findings
positive relation between past returns and beta
SML is less steep than in theory
Roll’s critique
Systematic risk measured relative to market portfolio which is proxied
International diversification distorts it
Without a market portfolio which reflects all risky assets, it is flawed
Fama and French not just beta
size and value improve the relationship between risk and return
5 APT factors, Chen roll and ross
Unexpected changes to :
Industrial ouptut
Inflation rate
Changes in:
ST and LT interest
bond risk premiums
Fama and French 3 factor
Size
market
Book to market
When did APT and CAPM give similar results
Banking oil and gas
When did APT and CAPM give different results
Machinery and electrical equipment
If we dont have fully diversified portfolio what does CAPM and APT tell us
we bear unsystematic risk the market doesnt compensate for
Why is international diversification good
Systematic risk in the UK can be unsystematic elsewhere and diversified away
Empirical findings on diversification in Denmark
under diversification costing Danish population 400m dollars annually
What does perpetuity mean
Payments received forever
Annuity definition
Pays fixed some for a specified number of years
Premium bond vs discount bond
Premium bond is more than face value,often due to lowered interest rates and discount bond is vice versa
What are the things affecting interest rate risk
Time to maturity- The longer the time, the greater the risk as interest rate more likely to change
Coupon rate- The lower the coupon rate, the more sensitive the value is to the interest rate
Things affecting corporate bonds rating
Financial risk, ability to make debt requirements, macroeconomic factors
Things affecting government bond ratings
Political risk, economic strength, gov debt, monetary and fiscal flexibility
Zero coupon bonds
These are bonds that do not pay coupons, they are normally initially available at very discounted rates
What are real interest rates
Rates that have been accounted for inflation
What does upward-sloping term structure mean
Long term interest rates are higher than short term interest rates
What is the difference between primary and secondary stock market
Primary is where firms release their stocks onto and they gain money through the initial selling of shares and can use the money to invest in operations.
Secondary is where people trade these stocks every day in order to try make money and companies earn no money through this trading.
Why are shares harder to value than bonds
Not even promised cash flows are known in advance
No maturity on the shares
No easy way to observe return the market requires
Blue chip stocks
high quality stocks such as coca-cola, shell, vodafone
Income stocks
High dividend stocks such as rio tinto, vodafone
Cyclical stocks
Fortunes directly tied to economy, Steel, cars
Defensive stocks
They are largely immune to economic changes, very low betas, unilever
Growth stocks
Do not pay high dividends, reinvest their money for more returns, JD , Greggs
Speculative stocks
Get rich quick stocks, often small firms with more upside potential, often much riskier than other stocks
What are synonyms for required return
Cost of capital and appropriate discount rate
What does the WACC tell us
The firms overall cost of capital is a weight average of the costs of the various components of the firms capital structure
Does a firm want a maximised or minimised WACC
minimised WACC means maximised value of the firm
What are preference shares
Right to receive dividends
Do not carry voting rights
constant dividends
Why is WACC important
companies use it as overall measure of wealth
as input in investment appraisal method
What do we mean by leverage
The proportion of debt in the capital structure
Also known as gearing
What is business risk
The risk associated with a companies profits and earnings due to systematic influences on the sector
What is financial risk
Volatility of distributable profits arising form the need to meet interest payments.
what is the M&M 1 no corp tax proposition
The market value of any firm is independent of its capital structure
What are the M&M assumptions
No tax
Perfect capital markets
no costs of financial distress
Individuals can borrow as cheaply as corporations
M&M proposition 2
expected rate of return pm the common stock of a levered firm increases in proportion to debt to equity ratio
M&M with tax propose value of levered firm will be maximised if its 100% debt financed, why is this wrong
Firms carry little debt in capital structure
personal taxes
borrowers incur costs
Where does the theoretical optimum level of debt exist?
Where the present value of the tax savings is just offset by increases in PV of financial distress
What are the costs of financial distress
Bankruptcy - Direst, legal and administrative costs.
Lehman brothers paid 5.9 billion
Customers and suppliers are careful if firms mightn’t be around for long.
Agency- conflicts of interest between debt and equity holders
What is pricing efficiency
The prices of capital market securities, fully and fairly reflect all information concerning past events and all events expected to occur in the future
What is the brief overview of efficient market hypothesis
share prices change instantly and without systematic biases
new information is unpredictable so price changes are a random walk
No opportunity for abnormal returns
Explain a random walk
Todays change in share price, t, cannot be used to predict tomorrow’s
No correlation between share price changes in one period and another period
What is a technical analyst/ chartist
research to identify mispriced securities through stock patterns.
no evidence to suggest it works after transaction costs are accounted for
What is fundamental analysis
This is where people study the companies fundamentals in order to find true value of firm.
Specialise in specific sectors
Do not exceed normal returns by a margin tat covers transaction costs.
What are the three levels of EMH
Weak form
Semi strong
Strong
What is weak form efficiency
This is where stock prices reflect all past information
Making abnormal returns by looking at historic data is not possible.
What is semi-strong efficiency
Current share prices reflect past and all publicly available information
No advantage in analysing public information once released as already absorbed into stock price
Strong efficency
Current share prices reflect all past data as well as public and private information
It is not possible to make abnormal returns
Evidence testing weak-form
Serial correlation, determines the relationship between same variable over different periods, finds there is a very small relationship
Evidence of semi-strong
Event studies, check if information is absorbed in one single jump. No evidence of abnormal returns
Manipulation of earnings- Depreciation rates applied to assets can be changed, semi strong should not be fooled by this. However collapse in ENCRON share price indicates a misleading.
Evidence of strong form
markets are not strong form efficient, insider trading has been made illegal since 1980 in the UK. High ups in companies have to report amount and date of sale 90 days before completion of sale
Small firm effect EMH
Returns from investing in smaller companies, have been shown in the long run to be greater than the average for all companies.
Compensation for larger risk
Less information available
Higher growth prospects
Book to market effect EMH
High book to market carry higher risk as more likely to be in financial risk so offer greater returns, after controlling for size and book to market effects, beta has no power
Value effects EMH
Above average returns can be made by investing in high value stocks, low price to earnings ratios.
Return reversal
Over the long term (3-5) years, stocks that perform badly tend to perform well for next long period and vice versa
Overreaction hypothesis, losers get pushed down too far and winners get pushed too high
Momentum effect
Tendency for poorly performing stocks over 3-12 months to continue that bad performance.
Underreaction and overreaction are the causes, herding for overreaction
Seasonal, calendar, cyclical effects.
Systematic abnormal returns on friday relative to falls on monday.
Bed and breakfast deal- In april many firms sell their losses just before tax year ends and then rebuy just into the new tax year.
30 day rule was banned om 1998, have to wait 30 days to repurchase now
Implication of EMH on Investors
Paying for investment research will not provide abnormal returns
Studying published accounts will not produce above average returns
no bargains in the stock market
Price is fair so increased trust, this leads to better allocative efficiency in the market.
Cost of paying fund managers
Implication of EMH on Companies
Correct signal to managers
Share price fairly reflects its value and market expectations
Performance- shares provide feedback to managers
Cosmetic manipulation will not mislead the market
Ability for firms to raise finance is affected- it gives firms the required rate of return because the price is correct. As firms measure their value as income/cost of capital, by having the correct return it gives the correct value
Implication of EMH on fundamental and technical analysts
It is not possible to make abnormal gains if markets are efficient. However due to these analysts searching for abnormal returns, it increases the speed in which prices absorb new information
Implication of EMH on shareholders
EMH provides vital link between overall value of firm and market price of its shares, taken as measure of shareholder wealth
What leads to the birth of behavioural finance
Numerous anomalies found within the efficient market hypothesis
What is the behavioural finance approach
To understand why investors make observed decisions
Explain expected utility theory
People have complete information about outcomes
Can evaluate their options
Optimal choice is highest possible expected utility
People are risk averse
Explain prospect theory
Utility function is replaced by a value function
Losses are twice as painful as gains
People choose most important actions that satisfies their most important needs
What is a heuristic
An intuitive decision making procedure that people can use for problem solving
Explain familiarity
An investor will choose to add a stock that they know or think they know
Taking advantage of the information in investors environment can make a heuristic friction efficient and optimal
Home bias investors are optimistic about their markets
Representativeness
People often assume that a particular outcome is broadly representative of a larger class
Judging things by how they appear rather than statistical likelihood
Gamblers fallacy
When people assume that a departure from the average, will be corrected in the short run
Affect and feelings
The reliance on instinct instead of analysis in making decisions, instinct, intuition and experience should complement formal analysis not substitute for it.
In behavioural finance are people risk averse or risk loving
If things are perceived as gains, people are risk averse
If things are perceived as losses, people are risk loving
Explain mental accounting and talk about dividend vs capital
Form of framing where people segregate certain decisions. Separate things into pots in their head
A dividend pound is different to a capital gains pound as they are put into two separate accounts and people are willing to spend the dividend pound
House money
Investors are more willing to accept risk after a positive morning as they are using money form their winnings
Leads to greater volatility in stock prices
Disposition effect
Tendency to hold on to losses for too long and selling winners too soon.
Fear of regret could be the reason for holding on to losses. On the other side selling a winning stock to soon to feel sense of pride
over confidence
Investors tend to exaggerate their talents and underestimate the likelihood of bad outcomes
Leads to excessive trading which evidence shows leads to fall in average returns
Self attribution bias
Attribution return outcome consistent with their predictions to their skill, but inconsistent outcomes are bad luck, reinforces overconfidence
Confirmation bias
Investor more likely to look for information that supports their original idea rather than contradicts it
How does irrational investors help the EMH
Irrational actions cancel each other out which leads to correct pricing
Arbitrage definition
Act of exploiting price differences on the same or similar securities by simultaneously selling overpriced and buying under priced security
Limits to arbitrage
Fundamental risk
Noise trader risk
Implementation costs
Law of one price
Why does fundamental risk occur
It exists because of the potential for rational revaluation as new info arrives
Explain what fundamental risk is
If an arbitrageur thinks a particular stock is over valued, they will short-sell it.
New info might arrive which causes the price to rise further
Price might converge to intrinsic value but may nit be within traders investment horizon
VW short squeeze
In 2008 a number of hedge funds sold vow shares short thinking the price will lower as have gloomy outlook
Porsche gained control of 74% of shares
Price went from 200-1000 euros and there was not enough stock for hedge funds to buy so lost lots of money
Noise trader risk
Opinion on value based on misinformation
Wring prices may become even more wrong in the short run
It is a systematic risk
Arbitrageur may have to liquidate early and sustain steep losses
Implementation costs
Short selling is:
Expensive- cost of correcting mispricing may exceed potential gain
Difficult- lack of availability
Legal factor- pensions and mutual funds have strict limits
All limit ability of arbitrage activity to force prices to be fair
Law of one price
Identical assists should have identical prices
Law of one price example
Royal Dutch and Shell - 60-40 split so Dutch should be 1.5 times more expensive . In 1993 Dutch was more than 1.5 times, buy shell and short sell royal Dutch
What is a bubble
Observed prices soar far higher than fundamentals and rational analysis would suggest, easy to identify once over but not whilst in one
BAPM
Assumes beta isn’t a sufficient measure of risk and social status should be involved
Argument against behavioural asset pricing
Easy to reverse engineer an explanation to an anomaly
Extent to which limited rationality affects asset pricing remains controversial
What are options
Special type of financial asset which gives the holder the right not obligation to buy or sell a particular asset at a predetermined price.
call option
Gives the holder the right to BUY share for specified price on or before a specified date
Put option
Gives the holder the right to SELL share for specified price on or before a specified date
American vs European
American - can buy on or before date
European- can only buy on the date
Value of call
Max{0,S-X} where S is share price and X is strike price
Value of put
max{0,X-S}
What is the premium
The premium denoted A is the amount the person pays to gain the option
What does In the Money mean?
it is profitable to exercise the option at assets current price
Uses of options
Can be used to hedge
-Adverse interest rate movements
-Adverse exchange rates movements
-Pass the risk of the portfolio over to someone else, protective put
-Can be used for pure profit reasons
What two things does an option premium consist of
Intrinsic and time value
What is intrinsic value for call option
Cash price - strike price
What is time value for call option
Option premium- intrinsic value
Bounds on option prices
C<S> S-Xe^-r(T-t)
Explained using no arbitrage principle</S>
Assumptions of black-Scholes model
No dividend or interest during lifetime
European option
Fixed risk free rate
No taxes or transaction costs
Prices of underlying asset are log normally distributed
How do the variables increasing affect option value
Price volatility leads to increase in option value
Time to expiration leads to increase
Exercise price leads to a decrease
Current stock price and interest rates lead to an increase
Why does it make sense to sell option before expiration
Before expiration it has some time value, holder should be able to get more than S-X in the market place
Practical issues with Black-Scholes
Variance and risk free rate assumed constant but these vary
Large prices were more frequently observed in real world than implied in model
Lognormal dust is a questionable assumption
How does time to expiration affect call option price math based
For the mathematical reasonings as the second part of the equation is -Xe^-r(T-t), as T-t gets larger , the equation gets smaller , this leads to the whole equation getting larger.
Time to expiration affect price, economic based
As we are further from the expiration time, this means there is a larger time value for the share, as there is longer for the underlying asset to change price, there is a higher chance that the price will go further above the strike price.
How does share price affect call option value
If the share price is higher, that means at expiration we have a larger S-X which means more profit will be made, as the holder of the option will be making more money, the price of the option increases.
How does interest rates affect call option value
- As r increases we get that e^-r get smaller and as we subtract this away from the first part of the equation, it means we get a larger value for the option.
- As well as this, if R increases, as the option is priced less than the share as we have no arbitrage in the model, we can invest the left over money we have saved by buying the option and invest that in the risk free rate meaning it generates more money.
Strike price effect call option value
If the strike price increases with everything else staying constant. This means that S-X will be smaller and less profit being made which decreases the price of the option.
How dos volatility affect the price of call option
If a stock is more volatile, this means that there is an increased chance that the price of the underlying asset is above the strike price than a less volatile stock that doesn’t move as much. Therefore, as there is a higher chance that the option will be in-the-money, the value of it is higher.
