Short Answer Questions Flashcards
What is the CML?
- a line representing expected returns of efficient portfolios in relation to their total risk
What is the SML?
- security market line
- a line representing the linear relationship between expected returns of any risky assets/portfolios and their systematic risk
Explain the term SMB
- Small-minus-Big.
- the difference in returns between a portfolio of small firms and a portfolio of big firms.
- SMB stands for the market required excess return associated with the risk of investing in small firms (compared to big firms)
- SMB represent the extra return the market expects for taking on the risk of investing in small firms (compared to big ones)
Explain the HML
- High-minus-Low.
- the difference in returns between a portfolio of high BE/ME (value) firms and a portfolio of low BE/ME (growth) firms.
- HML represents the extra return the market expects for taking on the risk of investing in value companies (as opposed to growth companies)
Briefly explain the CAPM
- The Capital Asset Pricing Model is an equilibrium model, in a competitive market, that states that the expected return of any risky security/portfolio is a linear function of its systematic risk, .
- provide equation, explain each variable
- systematic risk
- risk/return trade off
- purpose of CAPM
Explain beta
- a measure of a security/portfolio’s sensitivity to market movements
- specifically to changes in the value of a benchmark index.
Systematic risk (CAPM)
- CAPM focuses only on systematic risk (market risk) because it assumes investors can eliminate unsystematic risk (asset-specific risk) through diversification
Risk/Return trade off (CAPM)
- CAPM shows that the expected return on an asset increases with higher systematic risk.
- Higher-beta assets are expected to yield higher returns to compensate for their greater exposure to market volatility
Purpose of CAPM
- CAPM helps investors and managers estimate the required return on an investment
- assisting in decision-making on project investments, and portfolio management based on risk-adjusted returns
What is WACC?
The WACC stands for weighted average cost of capital.
- It represents the average cost of
financing a company’s operations.
- WACC incorporates the costs of both equity and debt
What is WACC used for?
- The WACC is typically used as a benchmark discount rate to evaluate potential investments or projects.
- Companies usually aim to reduce WACC because a higher WACC indicates higher financing costs, potentially making investments less attractive
What factors contribute to the determination of a
company’s WACC?
Factors that contribute to WACC are:
- the cost of equity
- Cost of debt
- The company’s tax rate
- the respective weights of these components in the company’s capital structure.
Cost of equity (WACC)
The cost of equity reflects the shareholders’ required returns that match the company’s risk profile and their willingness to accept risk.
Cost of debt (WACC)
The cost of debt reflects the creditors’ required returns given the company’s ability to repay and their willingness to accept risk.
Fama and French three factor model
- An extension of the CAPM that adds two additional factors:
- Size Factor (SMB - Small Minus Big)
- Value Factor (HML - High Minus Low)
- empirical research has shown these factors can significantly affect returns
- Equation
