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Corporate Finance > Section 6 > Flashcards

Section 6 Flashcards

1
Q

what do we call “optimal sequential decision making”?

A

Real Options

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2
Q

Real Options but more simply are..?

A

options to modify projects

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3
Q

What is CAPM??

A

Asset pricing theory which determines the equilibrium interest of assets as a function of its characteristics (its covariance)

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4
Q

When the return on an investment is uncertain and its possible returns can be specified, its future returns can be represented by what?

A

Probability Distribution

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5
Q

What does a probability distribution show?

A

probability that each possible return will occur

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6
Q

What is the realized return?

A

sum of the dividend yield and the capital gain rate of return over a time period

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7
Q

is there or is there not a clear positive relation between stocks average return and its volatility?

A

no, through ought history at least

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8
Q

Do Large stocks tend to have high or low volatility?

A

low volatility

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9
Q

do larger stocks make for long term non-risky investments?

A

no

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10
Q

do all stocks have higher or lower risk and returns than would be predicted based on data for large portfolios?

A

higher risk and lower returns

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11
Q

volatility explains risk well but fails when?

A

well in large portfolios, not so well with individual securities

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12
Q

what is diversification?

A

averaging out independent risks in a large portfolio

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13
Q

what is independent risk?

A

risk that is uncorrelated and independent for all risk assets - can be eliminated in a diversified portfolio

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14
Q

what are common risks?

A

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.

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15
Q

what are the two kinds of risk from investing in stock?

A

idiosyncratic and systematic risks

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16
Q

what is idiosyncratic risk?

A

variation in stocks return due to firm specific news. this is also called firm specific, unsystematic, unique, or diversifiable risk

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17
Q

what is systematic risk?

A

undiversifiable risk. risk that market wide news will simultaneously affect value of all assets

18
Q

how do we typically measure mathematically the systematic risk of a stock?

A

beta

19
Q

what is a firms cost of capital for a project?

A

expected return that its investors could earn on other securities with same risk and maturity

20
Q

a common assumption when determining cost of capital and risk, in relation to beta, is?

A

assume project has same risk as the firm, or other firms with similar assets

21
Q

what is the market risk premium?

A

difference between market portfolio’s expcted reutrn and the risk free interest rate

22
Q

with investments that have a beta different than 1, the expected return is given by which model?

A

CAPM

23
Q

what is excess return?

A

difference between average return for the investment and the average return for treasury bills, which are generally considered risk free

24
Q

what is common risk?

A

risk that affects values of all risky assets; cannot be eliminated by diversification

25
Q

what is independent risk?

A

risk that is uncorrelated and independent for all risky assets; can be eliminated in diversification

26
Q

what is diversification?

A

averaging out of independent risks in large portfolio

27
Q

what are common between firm specific, idiosyncratic, unsystematic, unique, or diversifiable risk?

A

risk arising from investing in a risky asset that is due to potential firm specific news and events

28
Q

what is systematic, undiversifiable, or market risk?

A

risk that market wide news and events will simultaneously affect value of all assets

29
Q

what is an efficient portfolio?

A

portfolio of risky assets that contains only systematic risk. changes in the value of this portfolio correspond to systematic shocks to the economy

30
Q

what is a market portfolio?

A

contains all risky assets in the market. standard to use s&p 500 portfolio as proxy for unobservable market portfolio of all risky assets

31
Q

how do we calculate the expected return of a stock?

A

weighted average of possible returns, where the weights correspond to the probabilities

32
Q

what are the two most common measures of risk, and how are they related to each other?

A

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

33
Q

how do we estimate the average annual return of an investment?

A

average of the realized returns for each year

34
Q

what is excess return?

A

difference between average return for the investment and the average return for treasury bills, a risk free investment

35
Q

do expected returns of a well diversified large portfolio of stocks appear to increase with volatility?

A

yes - there is positive relation between standard deviation of portfolios and their historical returns

36
Q

do expected returns for individual stocks appear to increase with volatility?

A

no- no clear relationship between volatility and return of individual stocks.

37
Q

what is the difference between common risk and independent risk?

A

common risk is the risk that is perfectly correlated across assets. independent risk is the risk that is uncorrelated and independent across assets

38
Q

explain why the risk premium of diversifiable risk is zero

A

because risk can be eliminated in a large portfolio. investors are not compensated for holding firm specific, or unsystematic, risk

39
Q

why is the risk premium of a security determined only by its systematic risk?

A

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

40
Q

what is the market portfolio?

A

contains shares of all stocks and securities in market

41
Q

how can you use securities beta to estimate cost of capital?

A

by determining the expected return using CAPM

42
Q

if a risky investment has a beta of zero, what should its cost of capital be according to the CAPM?

A

should equal risk free rate because it has no systematic risk

Corporate Finance (13 decks)

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