The Cost of Capital (Read slides) Flashcards

1
Q

What does giving different weights to available assets allow investors to do?

A

Build portfolios with different risk/return profile

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2
Q

What does a perfect investment world look like? (The assumptions)

A
  • People trade actively in the market (marginal investors)
  • Investors are risk-averse and well diversified
  • Diversification has no cost
  • Investors have homogenous expectations
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3
Q

Who are marginal investors? (2)

A

Are wholesaler investors who hold large shares within many companies.

Actively trade these shares so they can affect the price of these shares through trading.

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4
Q

What is the ultimate goal for investors?

A

Make investments with the best risk-return trade-off

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5
Q

What shape is the efficient frontier for assets?

A

Looks like the ln graph but doesn’t cross the risk axis and plateaus higher.

Y-axis= return
X-axis= risk

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6
Q

What does free diversification and diversified investors mean for risk in a perfect world?

A

Only systematic risk is present

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7
Q

Are marginal investors price makers or price takers?

A

Price makers

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8
Q

What is the main argument as to why only marginal investors are in the majority of markets?

A

Assume that a diversified investor and a non-diversified investor are both looking at Disney. The latter looks at the stock and sees all risk. The former looks at it and sees only the non-diversifiable risk. If they agree on the expected earnings and cash flows, the former will be willing to pay a higher price. Thus, the latter will get driven out of the market

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9
Q

What is meant by homogenous expectations?

A

Everyone has the same view/assessment of the risk and return for an asset so has the same efficient frontier of risky assets

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10
Q

There exists a ‘certain’ risky asset, when combined with a risk-free asset, that…

A

…offers the highest return for an level of risk

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11
Q

What does this combination of a risk free asset and certain risky asset look like on the risk and return diagram?

A

Look at slides for this slide

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12
Q

What does the risk of a well-diversified portfolio depend on?

A

the market risk of the securities included in the portfolio

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13
Q

What is the risk of any asset/security? Therefore, what is there?

A

The risk that it adds to the market portfolio

Correlation between the asset and market portfolio

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14
Q

What is a market portfolio?

A

A theoretical bundle of investments that includes every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market

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15
Q

What does the equilibrium security return depend on? What does is the implication of this?

A

The asset’s systematic return (not its total risk- standard deviation)

The riskiest stock with the highest standard deviation (total risk) does not necessarily have the largest expected return.

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16
Q

What should an investor not expect to receive additional return for?

A

Bearing unsystematic risk

17
Q

What is beta?

A

A measure of the non-diversifiable risk for any asset, as the covariance of its returns with returns on market portfolio divided by the variance of the returns on the market.

18
Q

What is a simpler description of what beta is?

A

Sensitivity of stock’s return to return on market portfolio
Standardised measure of correlation between the asset and the market portfolio

19
Q

What is the value of beta for a market portfolio?

A

Market portfolio/ market index = 1

20
Q

In practice. what is beta?

A

The estimated slope coefficient of the line that fits returns on the asset and those of a market index

21
Q

What is the value of a beta for a risk free asset?

A

0

22
Q

How do we interpret beta if b > 1?

A

Security risk higher than market risk, i.e. the returns on the asset are more variable in response to systematic risk factors than is the overall market

23
Q

How do we interpret beta if b = 1?

A

Security risk equal to market risk

24
Q

How do we interpret beta if b < 1?

A

Security risk lower than market risk, i.e. the returns on the asset are less variable in response to systematic risk factors than is the overall market

25
Q

Let ri = expected (required) return on asset i, and rm = return of market.

How do you calculate the..
a) risk premium on asset i
b) market risk premium
c0

A

Risk premium = beta × Market Risk Premium