Week 4 - Capital Markets And The pricing Of Risk Flashcards
What is the ‘Capital Asset Pricing Model’ and what is it used for?
The ‘Capital Asset Pricing Model’ describes the risk associated with a stock taking into account the risk of the individual stock and the risk of the market as a whole.
What are the tree assumptions of the ‘CAPM’ model?
- Investors can buy and sell securities at competitive market prices (without tax or transaction costs) and can borrow and lend at the risk-free interest rate.
- Investors only hold efficient portfolio of securities ( Portfolios that yield the maximum expected return given the level of volatility).
- Investors have homogenous expectations.
What is the ‘Capital Asset Pricing Model’ (CAPM) formula?
CAPM = Rf+Bi (ERm-RF)
Risk free rate + Beta (Expected return of market - Risk free rate)
What is the ‘Beta’ of a stock?
The Beta of a stock is the level to which the stock corresponds to movements in the market
What ‘Beta’ does the stock market as a whole have ?
1
What does a high ‘Beta’ indicate?
The stock moves with the market
What does a low ‘Beta’ indicate?
The stock moves more independently of the market.
What does the term ‘Market capitalisation’ refer to?
The total monetary market value of a companies outstanding shares
What is ‘Market Capitalisation’ used for by investors?
Determining a company’s size
What is the formula for ‘Market capitalisation’?
Market capitalisation = (Number of shares outstanding) x (Price per share)
What is a ‘Value-Weighted portfolio’? And How is it calculated?
The value of a security in relation to the overall portfolio.
Value-Weighted = Market Value of Shares/ Total Portfolio Value
What is an ‘Equal-Opportunity’ portfolio?
Each stock in the portfolio is given the same amount of weighting.
Smaller firms are held at the same weight as larger firms
What is an ‘Exchange-Traded Fund’ (EFT)?
Ownership in an Exchange-Traded Fund reflects ownership in a portfolio of stock. Not individual stocks.
Where does the ‘Risk-Free Rate’ come from in the US?
The yield of U.S Treasury Bonds between a term of 10-30 years.
What is the ‘Historical Risk Premium’? And What are the two drawbacks of using it?
The risk premium (ERm-RFR) calculated using historical data.
- Standard Error of the estimates are large.
- Backwards looking, so may not represent current expectations.
What is the formula for calculating ‘Beta’?
Beta = Correlation with market x Volatility of stock/ Volatility of market
What is the ‘Debt-Cost of capital’? And What are the two ways it can be calculated?
The expected return required from a firms creditors.
- Yield to Maturity
- Using the debt betas
What is the ‘Yield to maturity’ and How is it used to calculate the debt cost of capital?
Yield to Maturity is the IRR an investor can expect from holding a bond to maturity.
Dcc = (1-p)Y + p(Y-L)
P = Probability of default Y = Yield to maturity L = Expected loss per £1 of debt in the event of default
What are the 3 steps to calculating the ‘Weighted Average Cost of Capital’?
- Calculate the Value of each security as a proportion of the firms market value.
- Determine the required rate of return on each security.
- Calculate a weighted average of these required returns.
What is the ‘Weighted cost of Capital’?
The weighting of debt and equity that make up the capital of a firm
What is there ‘Weighted Average Cost of Capital’ formula?
rWACC =Wdebt X Rdebt (1-t) + Wequity X Requity
What is the ‘Unlevelled Cost of Capital’ rU?
The Unlevelled Cost of Capital is equal to WACC pre-tax.
In calculating WACC, the value used to achieve the weightings of both debt and Equity is not the Book value but the…
Market value
How is the market value of a debt calculated?
PV of all coupons and par value discounted at the current interest rate
How is the market value of equity calculated?
Market price per share multiplied by the number of outstanding shares (market capitalisation)
What is the ‘Pure Play Technique? And What makes a firm a ‘Pure Play’?
Attempts to estimate ‘Risk-adjusted required returns’ by matching a project to some publicly traded company in the same line of business.
Firms need to be as similar as possible. Consider:
- Geographical region
- Industry
- Growth stage
- Exposure to the same Operational risks
What are the 6 steps in the pure play technique?
1) Identify pure-play firms
2) Determine Betas for pure plays
3) Adjust for leverage the betas obtained
4) Re-leverage for our beta
5) Calculate the projects cost of equity
6) We can now calculate the WACC
How is a Beta adjusted for leverage?
Bu (1+(1-t)* D/E)
What does holding high amounts of cash mean for a firms assets risk?And How is net debt calculated?
High cash holdings = Lower Risk (Cash is risk-free)
Net debt = Debt - Excess Cash and Short-Term investments
What is ‘Operating Leverage’?
Operating leverage is the relative proportion of fixed versus variable costs.
When a firm has higher Fixed Costs, how should the ‘Cost of Capital’ reflect this?
The cost of capital should be higher
