Week 8 Flashcards
Have stocks always been the preferred asset of investors?
No, it used to believe that bonds were best.
What is a margin rate?
A margin rate has two meanings, firstly, it is a leverage ratio, given by the position margin divided by the position value. This could also be known as a lending ratio, the position margin is the cash money you invest when you buy a stock, while the position value is the value of the investment(your cash + borrowed).
A margin rate also refers to the interest rate charged on the money borrowed from a broker.
What are a few common return measures? What is the price relative?
The simple gross return is given by 1 + Rt (price now/price before, this ratio is known as the price relative).
The simple net return is Rt ((price now/price before)-1), this can also include the dividend if wanted by adding to the price now.
The continuously compound return rt is equivalent to (ln(1+Rt)) the log of the gross return.
Why can we not just take the arithmetic mean of a series of stock returns to get the average return?
If a stock goes up by a net return and then down by the same amount the ending price is:
Initial price *(1+net return) * (1-net return) = (1-net return^2), this means it will be less than 1 * the initial price, even though the arithmetic mean was 0. However, arithmetic averages of continuous compounded returns to work for calculating average economic gains. As do geometric averages of simple net returns.
What is a geometric average?
(1+x1 * 1+x2 * 1+x3 * … * 1+xn)^1/n - 1
What does 1+geometric net return equal?
e^(arithmetic average continuous compounded return)
Why are arithmetic averages of simple net returns misleading? Why does it work with continuous compounded returns? What about geometric?
Arithmetic averages compound via addition, but simple net returns compound with multiplication. Continuous compound returns compound by adding and as such work with the arithmetic average, but not the geometic average, as the geometric average compounds via multiplication.
What is momentum in stocks?
This typically refers to price momentum, and is a technical analysis technique. It could also refer to earnings momentum or revenue momentum.
How do continuous compounding returns lead to geometric Brownian motion?
Over small successive intervals of time, continuous compounding returns are both independent of each other and normally distributed, because continuous compounding returns compound via addition their sum must be standard normal as well. As the number of continuous compounding returns approaches infinity and the sub interval is tending to 0, the normally distributed returns become very small, and bounce up and down from second to second, this pattern is known as geometric Brownian motion.
What does a sub period’s continuous compounding return value equal?
What parts are there?
the annual mean return * the length of the sub period + annual standard deviation of returns *sqrt(length of the sub period) * a standard normal random variable.
This is composed of two parts, the first is a drift at annual mean return rate, over the short interval length.
The second part is a diffusion of the standard normal, with the annual standard deviation * sqrt(interval length) acting as a sensitivity term on the standard normal.
What are the accuracies of estimates of the annual mean return and variance of returns like using continuous compounding returns?
Does this stick to overall trends in finance?
With the assumption that the continuous compounding returns are independent and normally distributed the variance estimator becomes much more accurate as the interval length gets smaller, while the annual mean return estimator doesn’t get more accurate.
In actual finance means are typically estimated poorly (mean blur) but variances are comparatively estimated quite well. With more years of data making both more accurate.
Why can using a t test on actual continuous compounded returns be problematic?
If we do so we violate some t-test assumptions, in reality returns are not normal because of peakedness and fat tails, they aren’t independent because of autocorrelation, and the parameters of the underlying distributions will surely not be identical after many decades.
Is technical analysis typically short-term or long-term oriented? How about fundamental? Are they exclusive?
Technical analysis is typically short-term and fundamental analysis more long-term. A manager can mix these techniques based on their needs.
What is a fundamental price of a stock? What is a common model type that gives these?
An assessment of intrinsic value of a stock on a per share basis found by analysing fundamentals.
Most dividend discount models of stocks give a fundamental price.
What are some of the major takeaways from Lynch’s book “one up on wall street”?
Lynch argues that everyone knows something, as they companies that they like as they go about their lives. He also walks through how we should think about a stock before we but it, talks about classifying stocks by rate of growth of their earnings per share as slow growers, stalwarts or fast growers.
He also classifies stocks as cyclicals or not, which come in two types, those whose earnings vary with broad economic cycles, and those whose earnings vary with some type of event, like war build up.
He also says to ensure the balance sheet is strong, dividends are healthy, and to understand the cash position, generation of free cash flow, and the profit margin.
