Topic 4 - Risk of Corporate Finance Flashcards
Fisher Equation - Inflation
The real return is
(1 + r) = (1+R) / (1 + h)
Geometric mean
=( (1+return)*(1+return year n))^1/n - 1
Systematic Risk
The portion of an assets risk attributed to the market factors that affect all firms and cannot be eliminated through the process of diversification
unsystematic risk
the portion of an assets risk which is firm specific and can be eliminated through the process of diversification
Total Risk
Systematic Risk + Unsystematic Risk
Systematic Risk Principle
The expected return on a risky asset depends only on that assets system risk since unsystematic risk can be diversified away
What is the measure of the systematic risk of an asset?
We use the beta coefficient to measure systematic risk
Beta measures the responsiveness of a security to movements in the market
Market beta βm = 1
Therefore if:
βA= 1, the asset has the same systematic risk as the overall market
βA < 1 implies the asset has less systematic risk than the overall market
βA > 1 implies the asset has more systematic risk than the overall market
What is the overall market?…
A well diversified portfolio incorporating all asset classes
Proxy for the market portfolio: share market index
Beta formula
Beta A = covariance A,m / variance m
What is SML
SML slope = Reward to Risk Ratio of the Market = = Market Risk Premium
In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market
If not, assets are undervalued or overvalued
Efficient Capital Markets
Are stock returns predictable?
Stock prices are in equilibrium or are “fairly” priced.
Prices fully reflect all available information.
If this is true, then you should not be able to earn “abnormal” or “excess” returns.
Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market.
Efficient Market Hypothesis or EMH
Eugene Fama – 1970, Journal of Financ
Different types of efficient capital markets
What is weak form efficiency
Prices reflect all past market information such as price and volume
If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information
Technical analysis using past price charts, returns, volatility and market statistics will not lead to abnormal returns
Empirical evidence:
Markets are generally weak form efficient
What is semi-strong form efficiency
Prices reflect all publicly available information including trading information, annual reports, press releases, etc.
If the market is semi-strong form efficient, then investors cannot earn abnormal returns by trading on public information
Fundamental analysis will not lead to abnormal returns
What is strong form efficiency?
Prices reflect all information, including past, public and private
If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they possessed
Empirical evidence:
Markets are NOT strong form efficient and that insiders could earn abnormal returns
Why does EMH matter
If prices DO fully reflect all current information, it would not be worth an investor’s time to use information to find under-valued securities.
If prices DO NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.
Common misconceptions about EMH:
An efficient market doesn’t mean “you can’t make money”!
It means that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns
Market efficiency will not protect you from wrong choices if you do not diversify – you still don’t want to put all your eggs in one basket
