Section 6 Flashcards
what do we call “optimal sequential decision making”?
Real Options
Real Options but more simply are..?
options to modify projects
What is CAPM??
Asset pricing theory which determines the equilibrium interest of assets as a function of its characteristics (its covariance)
When the return on an investment is uncertain and its possible returns can be specified, its future returns can be represented by what?
Probability Distribution
What does a probability distribution show?
probability that each possible return will occur
What is the realized return?
sum of the dividend yield and the capital gain rate of return over a time period
is there or is there not a clear positive relation between stocks average return and its volatility?
no, through ought history at least
Do Large stocks tend to have high or low volatility?
low volatility
do larger stocks make for long term non-risky investments?
no
do all stocks have higher or lower risk and returns than would be predicted based on data for large portfolios?
higher risk and lower returns
volatility explains risk well but fails when?
well in large portfolios, not so well with individual securities
what is diversification?
averaging out independent risks in a large portfolio
what is independent risk?
risk that is uncorrelated and independent for all risk assets - can be eliminated in a diversified portfolio
what are common risks?
risk that affects the value of all risky assets, and cannot be eliminated in a diversified portfolio. eg, earthquake insurance policies in a portfolio of earth-quake policies in same geographic area.
what are the two kinds of risk from investing in stock?
idiosyncratic and systematic risks
what is idiosyncratic risk?
variation in stocks return due to firm specific news. this is also called firm specific, unsystematic, unique, or diversifiable risk
what is systematic risk?
undiversifiable risk. risk that market wide news will simultaneously affect value of all assets
how do we typically measure mathematically the systematic risk of a stock?
beta
what is a firms cost of capital for a project?
expected return that its investors could earn on other securities with same risk and maturity
a common assumption when determining cost of capital and risk, in relation to beta, is?
assume project has same risk as the firm, or other firms with similar assets
what is the market risk premium?
difference between market portfolio’s expcted reutrn and the risk free interest rate
with investments that have a beta different than 1, the expected return is given by which model?
CAPM
what is excess return?
difference between average return for the investment and the average return for treasury bills, which are generally considered risk free
what is common risk?
risk that affects values of all risky assets; cannot be eliminated by diversification
what is independent risk?
risk that is uncorrelated and independent for all risky assets; can be eliminated in diversification
what is diversification?
averaging out of independent risks in large portfolio
what are common between firm specific, idiosyncratic, unsystematic, unique, or diversifiable risk?
risk arising from investing in a risky asset that is due to potential firm specific news and events
what is systematic, undiversifiable, or market risk?
risk that market wide news and events will simultaneously affect value of all assets
what is an efficient portfolio?
portfolio of risky assets that contains only systematic risk. changes in the value of this portfolio correspond to systematic shocks to the economy
what is a market portfolio?
contains all risky assets in the market. standard to use s&p 500 portfolio as proxy for unobservable market portfolio of all risky assets
how do we calculate the expected return of a stock?
weighted average of possible returns, where the weights correspond to the probabilities
what are the two most common measures of risk, and how are they related to each other?
the two most common measures of risk of probability distrbution are variance and standard deviation. variance is expected squared deviation from the mean, and the standard deviation is the ware root of the variance
how do we estimate the average annual return of an investment?
average of the realized returns for each year
what is excess return?
difference between average return for the investment and the average return for treasury bills, a risk free investment
do expected returns of a well diversified large portfolio of stocks appear to increase with volatility?
yes - there is positive relation between standard deviation of portfolios and their historical returns
do expected returns for individual stocks appear to increase with volatility?
no- no clear relationship between volatility and return of individual stocks.
what is the difference between common risk and independent risk?
common risk is the risk that is perfectly correlated across assets. independent risk is the risk that is uncorrelated and independent across assets
explain why the risk premium of diversifiable risk is zero
because risk can be eliminated in a large portfolio. investors are not compensated for holding firm specific, or unsystematic, risk
why is the risk premium of a security determined only by its systematic risk?
because investors cannot eliminate systematic risk they must be compensating for holding that risk. as a consequence, risk premium for a security depends on the amount of its systematic risk rather than its total risk
what is the market portfolio?
contains shares of all stocks and securities in market
how can you use securities beta to estimate cost of capital?
by determining the expected return using CAPM
if a risky investment has a beta of zero, what should its cost of capital be according to the CAPM?
should equal risk free rate because it has no systematic risk
