Return Concepts

Question 0

If expected return is > required return, asset is _____ valued

Answer 0

Under

Question 1

Holding period return

Answer 1

HPR = P1-P0+CF1
—————
P0

Question 2

Equity risk premium

Answer 2

Equity risk premium = required return on equity index - risk free rate

Question 3

What are four types of estimates of equity risk premium?

Answer 3

Historical estimates
Forward looking estimates
Macroeconomic model estimates
Survey estimates

Question 4

Drawbacks and benefits of each equity risk premium calculation

Answer 4

Hist - straightforward, outdated
Fwd - current, requires updates
Macro - current, only developed countries
Survey - easy to get, wide disparity

Question 5

What are two models used to estimate equity risk premium

Answer 5

Gordon growth model

Ibbotsen-Chen (supply side)

Question 6

Calc Gordon growth model

Answer 6

P0 = D1
——
r - g

Question 7

Ibbotsen-Chen

Answer 7

Equity risk premium = ((1+infl)(1+rEg)(1+PEg) - 1 + DivYield) - RF

Question 8

What are 7 models used to estimate required return on equity

Answer 8

CAPM 
Multi factor model 
Fama-French model 
Pastor-Stambaugh model
Macroeconomic multifactor model 
Build up method 
Beta estimation

Question 9

Capital asset pricing model (CAPM)

Answer 9

Required return = risk free rate + equity risk premium*stock beta

Question 10

Multi factor model

Answer 10

Required return = RF + risk premium1 + … + risk premium n

Question 11

Fama - French model

Answer 11

Required return = RF + beta mkt,j* (Rmkt - RF) + beta smb,j* (Rsmall - Rbig) + beta hml,j * (Rhmb - Rlbm)

Market risk premium + small cap risk premium + value risk premium

Question 12

Pastor-Stambaugh model

Answer 12

Fama- French model + liquidity factor

Question 13

Build up method and macro variable methods

Answer 13

Build up - like risk premium, without betas

Macro multifactor - factors associated w/Econ vars - affect cf or discount rate

Question 14

How to estimate beta

Answer 14

Regress returns on publicly traded company stock provide a beta

Question 15

Adjust for beta drift using Blume method

Answer 15

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

Question 16

For thinly traded/non public companies, estimate beta by:

Answer 16

1. Identify public traded benchmark
2. Estimate benchmark beta
3. Unlever benchmark
4. Relever beta w/proper cap structure

Question 17

Strengths and weaknesses of CAPM, multi factor, build up models

Answer 17

CAPM: simple, low explanatory power
Multi: more explanatory, complex, expensive
Buildup: simple, based on historical, may not be relevant

Question 18

Steps to adjust beta for leverage effects

Answer 18

1. Unlevered B = (1/(1+D/E))*B levered

2. Relevered B = (1 + D/E)* Bu