Study Unit 5 Flashcards
ROI
Amnt rec’d-Amnt invested
Rate of return
ROI/Amnt invested
Systematic risk
mkt risk (undiversifiable risk)
risk faced by all firms
changes in economy as a whole (inflation, business cycle)
all investments affected
Unsystematic risk
unique risk or company risk
determined by industry, products, customer loyalty, degree of leverage, mgt competence,
diversifiable risk
Types of investment risk
credit default liquidity maturity (interest rate) inflation political exchange business country principal
Credit default
risk borrower will default and won’t pay principal or interest; gauge by using credit-rating agencies
Liquidity
security can’t be sold on short notice for MV
Maturity risk
interest rate risk
risk an investment security will fluctuate n value bet date of issue and date of maturity
longer the date of maturity, higher the risk
Political risk
probability of loss from actions of govts (tax law changes, environmental regs)
Exchange rate risk
risk of loss bc of fluctuation in relative value of foreign currency
business risk
operation risk
risk of earning fluctuations before interest and taxes or in operating income when firm doesn’t use debt
-risk inherent in its ops that excludes financial risk (risk to shareholders from use of financial leverage)
-depends on demand variability, sales price variability, input price variability, amnt of op leverge
Country risk
overall risk of investing in a foreign country
principal risk
risk of losing the amnt invested
risk averse
utility of gain doesn’t outweigh dis utility of potential loss of the same amnt
risk neutral
investors adopts expected value approach bc they regard utility of gain as = to dis utility of a loss of same amnt
risk seeking
optimistic attitude toward risk
utility of gain as exceeding dis utility of loss of same amnt
risk premium
excess of investment’s expected RoR over risk free interest rate (interest rate on safest investment, rate on US T bill)
T bill holder only exposed to inflation risk; mkt rate of interest = risk free rate of interest + inflation premium
required rate of return
return that takes into account all investment risks that relate to specific security
Real risk free rate + inflation premium=risk free rate
risk free rate+ liquidity risk premium + default risk premium+ maturity risk premium= required rate of return
Debt securities
income bonds pay return only if issuer is profitable
debentures are unsecured
mtg bonds are secured by real property
T bonds backed by US govt
Precious metal
risky b/c of volatility
when high inflation, currency loses purchasing power & may be safe investment
Probability distribution
set of all possible outcomes for decision
discrete b/c outcomes are limited
expected rate of return
investment determined using an expected value calculation
avg of possible outcomes weighted wrt probabilities
Ex RoR= sum (possible rate of return * probability)
Risk
chance actual return differs from expected
risk=std dev (variance) of investment’s return
std dev= sq rt[sum(possible rate of return-expected rate of return)^2 * probability]= sq rt (variance)
Coefficient of variation
measures risk per unit of return
CV=std dev/expected rate of return
lower the ratio better the risk return tradeoff
Diversification
expected portfolio return
portfolio risk
weighted avg of returns on indiv securities
less than a simple avg of the std deviations of component securities; benefit of diversification
benefits decrease when more than 20-30 different securities are held
coefficient of correlation
measures degree to which any 2 variables (prices) are related
- range from 1.0 to -1.0
- perfect positive (1.0) means variables move together
- perfect negative (-1.0) mans variables move opposite
- normal range of 2 random stocks is .5 -.7
CAPM
quantifies req ROE security by relating security’s level of risk to avg return available in the mkt (portfolio)
based on idea investor is compensated in 2 ways (time value of $ and risk)
-time value is risk free rate
-risk component consists of market risk premium (Rm-Rf) and beta
market risk premium
return provided by mkt over and above risk free rate
varies in direct proportion to beta
beta
measure of security’s risk
- effect of indiv security on volatility measured by sensitivity to movements of overall mkt
- beta of mkt=1, beta of US treasury = 0
security risk premium
beta(Rm-Rf)
CAPM formula
required RoR
Rf + beta(Rm-Rf)
Rm-market return
derivative instrument
investment trans in which the gain or loss derived from some other economic event (price of stock, foreign currency exchange rate, price of commodity)
-one party enters into trans to speculate (incur risk) other enters into it to hedge (avoid risk)
Hedging
offsetting instrument to minimize or avoid impact of adverse $ movement
-takes position correlated with original asset but in opposite direction
long position- entity owns asset, benefits when value increases
short position- entity sells asset it doesn’t own at time of
sale; take position when believe value will decrease (borrow asset from entity that owns it before “short sale”)
Options
buyer holds all rights; seller has all of obligation
buyer pays fee to dictate in future whether seller buys or sells underlying asset from or to the buyer
holder- party buying option; exercise of option at holder’s discretion
writer- seller
Exercise price
price holder can purchase (for call) or sell (put) the underlying asset
-increase in exercise price decreases value of call option and increase in value of put option
Price of underlying
price increases, value or call increases; exercise price is greater bargain with each adtl dollar in price of underlying
value of put decrease as price of underlying increases, no advantage in selling at a lower than mkt price
interest rate
rise in rate makes calls more attractive and increases value
rise in rate makes put option less attractive and decreases value
Volatility of price of underlying
holder prefers greater volatility b/c more chance underlying price will change and option will be in-the-money
more volatile, increase value of option
intrinsic value of a call option
amnt by which exercise price is less than current price of the underlying
positive i.v is in-the-money
0 i.v. out of the money
