Risk and Return Flashcards
Define Holding period return
Rate of return over given investment period. Its how much we get for each unit cash invested in security
What are the two components of return
Income component is dividends and capital gains
HPR = Div Yield + Capital gains yield
Define arithmetic average Return
Return earned in an average year over multiple years. What you earn in a typical year
Define geometric average Return
Average compound Return each year over multiple years. What you actually earn. Assumes Y1 is reinvested
Formula for geometric average return
[(1+R1) x (1+R2) x … x(I + Rt)]^1/t - 1
Define risk free rate
Return earned with certainty - short term government debt securities usually used (short maturity)
Define risk premium
Expected return in excess of that on risk free (reward)
Define excess return
Additional return earned by moving from risk free investment to risky one
What is the formula for expected return
Treasury bill(risk free) + risk premium
What are the qualities of an efficient capital market
Security prices should reflect all available info and has competition - prices fluctuate with new info as investors reassess asset values based on that info
What does the efficient market hypothesis state
Stock prices reflect all info. this means stock prices change unpredictably because information is unpredictable. - random walk
What are some sources of information that might lead to stock prices changing?
Government figure on GDP
Drop in interest rates/ rise in sales
Result from latest arms control talks
What is the formula for total return
R = E(R) + U where U is unexpected return
Define delayed reaction on stock market
Suggests inefficent market - New information means prices partially adjust
Define over reaction reaction on stock market
Suggests inefficent market - New information is overshooting price eventually correcting
Name the three versions of efficient market hypothesis
Strong form EMH
Semi strong form EMH
Weak form EMH
Explain the three versions of EMH
Strong form EMH - Stocks reflect all relevant info, even insider information
Semi strong form EMH - stocks reflect all public information already
Weak form EMH - Stocks reflect all information contained in history of trading - random component is due to new info
Define technical analysis
Search for unpredictable patterns in stock prices
Define fundamental analysis
Uses earnings, dividend prospects, expected interest rates, risk evaluation to determine the proper stock prices
Define scenario analysis
Possible economic scenarios: specify liklihood HPR ex: examining recession and boom
Define probability distribution
Possible outcomes with probabilities
Define event study
Technique of empirical financial research enabling an observer to access the impact of an event on a firms stock price
Define expected return
Return anticipates as return on a risky investment. Mean value of the distribution of realised returns - weighted average
Define variance
Expected value of squared deviation from mean - average squared difference between actual return and average return
Define portfolio
Group of assets held by investor
Define portfolio weight
% of portfolio’s total value in a particular asset
Define market risk/systematic risk
Risk attributable to market wide risk sources and remains even after extensive diversification is systematic risk or market risk
Define non systematic risk
Diversifiable, firm specific risk can be eliminated
What does the diversification principle mean
Means spreading an investment across assets (portfolios) eliminates some but not all of risk - some is systematic. Adding more stock to portfolios means deviation from expected return decreases too
What does systematic risk principle tell us about return on an asset
Expected return on asset depends only on its systematic risk as the unsystematic risk can be eliminated at no cost - hence there is no reward for bearing it
Define Beta coefficent
Measures sensitivity to market risk - amount of systematic risk in a risky asset relative to that in an average risky asset
What is the difference between risk premium and excess return
risk premium- expected return
excess return - realised return
If B<1 what does this mean
Stock has low volatility - defensive stock ex: coca cola
If B>1 what does this mean
Stock has greater volatility to fluctuating returns - aggressive/cyclical stock ( bought more in boom and less in recession)
If B=1 what does this mean
Market portfolio beta
If B=0 what does this mean
Beta of risk free asset
Define market risk premium
Difference between expected return on market and interest rate on the risk free asset
formula for risk premium on an asset
E(Ri) - Rf
In equilibrium what should reward to risk ratio be?
same for all assets
reward to risk for market = reward to risk for asset
What is principle of risk to reward ratio in equilibrium called?
Capital pricing model
Give the equation of the security market line and details of the graph
E(Ri) = Rf +[E(Rm)- Rf] x Bi - CAPM
Slope is market risk premium!
What is the fundamental relationship between beta and expected return
assets must have same reward to risk ratio and must plot all on the same straight line
If assets plot above/ below SML what does this mean?
Above - Unpriced (current price too low)
Below - Overpriced (current price too high)
