Return on Investment Flashcards
What is the time preference rate?
This is the return that investors require even in the absence of (a) the perceived risk or uncertainty of the return, and (b) the expected change in the purchasing power of money (inflation).
What is the risk premium?
It is an extra amount required by investors as compensation for any perceived uncertainty in the amount or timing of the expected return on a specific investment.
What is the time preference rate also known as?
The ‘real’ rate of return.
What is the nominal rate of return?
It is the real rate plus an allowance for the expected rate of inflation.
What is strong form EMH?
Strong form EMH states that all information, public or private, is already discounted in the price of a share.
<b>Example:</b> a CTO of a public technology company believes that his company will begin to lose customers and revenues knowing that the official rollout of a product will be a flop. This would be considered insider information.
The CTO decides to take up a short position on his own company, thereby betting against the stock price movement.
However, when the product is released, the stock price is unaffected. The market is therefore strong form efficient because even insider information about the product was already priced into the stock.
What is semi-strong form EMH?
Semi strong EMH states that all public information is already in the price of a stock.
<b>Example:</b> Suppose a company is trading at £10 the day before it is scheduled to report its earnings. A news report is published the evening before that claims the business has suffered in the last quarter due to adverse government regulation. When trading opens the next day, the company’s stock falls to £8, reflecting the publicly available information. The share price then jumps to £12 because the company has reported positive results on the back of a cost-cutting strategy. Thus, the movements in price relate to the publicly available information as it becomes available.
What is weak form EMH?
The weak form EMH states that the current price of a share already reflects all information incorporated into previous prices; each successive price move is a reaction to fresh info and there cannot be predicted from old prices.
<b>Example: </b> A market trader thinks they’ve seen the share price in Alphabet Inc. (GOOGL) continuously decline on Mondays and increase in value on Fridays.
They assume they can profit if by buying the stock at the beginning of the week and selling at the end of the week.
If, however, Alphabet’s price declines on Monday but does not increase on Friday, the market is considered weak form efficient. It does not follow a predictable path - all movements in price are completely random and only relate to new information which cannot be gleaned ahead of time.
What are examples of irrational investor behaviour?
- Overconfidence
- Optimism
- Representativeness
- Conservatism
- Belief perseverance
- Anchoring
- Availability biases
What is arbitrage?
Arbitrage is a risk-free way of making money out of mispriced securities, for example being able to buy a share cheaply in one market and immediately sell it at a higher price in another market.
What is belief perseverance?
It is a form of investor irrational behaviour that is characterised by the inability of people to change their own belief even upon receiving new information or facts that contradict or refute that belief.
What can over-confidence in a market lead to?
Overconfidence leads to overtrading and greater losses (Barber and Odean, 2001).
What is agency theory?
It is a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. e.g. principle = investor and organisation = agent.
What is the main assumption behind agency theory?
Agency theory assumes that both the principal and the agent are rational individuals seeking to maximise their own perceived self-interest.
What problems can exist between an <b>agent</b> and a <b>principle</b>?
Information asymmetry – the information available to the agent is not the same as the information available to the principal.
Uncertainty – the principal does not know on what information the agent’s decisions are based, or to what extent the outcome of the agent’s activity is determined by the agent’s decisions and to what extent by factors outside the agent’s control.
Adverse selection – the agent no longer makes the best decision for the principal but makes the decision which will appear best to the principal due to their lack of knowledge (information asymmetry).
Moral hazard - an agent who knows that their actions cannot be exactly monitored will tend to act in the agent’s best interests, irrespective of whether this is optimal for the principal.
What effect does a falling sharing price have on an organisation?
It makes it difficult to raise funds (finance) through issuing equity.
