finance 302 ****
What is beta? how is it related to expected return
beta measures market risk. it is the only risk measure that can not be diversified away. it should be directly related to expected return through CAPM.
leverage increases risk of financial distress. so if a company borrows money, shouldn't the value of the firm go down due to the higher risk?
If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing. No, tax shield. leverage arises bc of fixed debt services. since income is variable and leverage is fixed, it has the ability to amplify in both directions.
Explain what causes financial leverage?
Leverage arises because of fixed debt services. since income is variable and leverage is fixed, it has the ability to amplify in both directions. result of fixed debt service if income is variable then you have large fixed costs. bc earnings are variable and debt is fixed it causes variability in returns. Financial leverage is the additional volatility of net income caused by the presence of fixed-cost funds. The potential benefits are that if operating income is rising net income will rise more quickly.
Does the EMH imply pricing perfection? Do stock market bubbles disprove the EMH?
No, it implies that all available information and predictable information is exploited. but it is not included if it is not available. *it implies all avialbale info and predictable iinfo is reflected in the price. a stock market bubble is usually caused cognitive bias of participants in the market. they raise the price of the stock higher than its evaluation. This does not disprove the EMH
explain systematic risk and how to measure it ?
Systematic risk, also known as "market risk" or "un-diversifiable risk", is the uncertainty inherent to the entire market or entire market segment. Also referred to as volatility, systematic risk consists of the day-to-day fluctuations in a stock's price.. the variability of return that arises from market movements. measure it with beta. variability to rise from economic influences and cannot be diversified away.
What causes stock prices to fluctuate day to day
because of new and unpredictable information surprises make investors reevaluate and cause stock prices to change. ** surprise information relative to expectation**
explain why historical information should be useless in predicting the stock market?
because of the efficient market hypothesis . all value should have already been exploited. changes in prices are due to surprises which are unpredictable. historical info shoul dhave already been exploited so it has no value
how does beta differ from standard deviation as a measure of risk?
beta measures the market risk where Std Dev measures total variability regardless of its source. std dev covers total risk from all sources. The standard deviation essentially reports a fund's volatility, which indicates the tendency of the returns to rise or fall drastically in a short period of time. A security that is volatile is also considered higher risk because its performance may change quickly in either direction at any moment. The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its mean return, the average return of a fund over a period of time.*While standard deviation determines the volatility of a fund according to the disparity of its returns over a period of time, beta, another useful statistical measure, determines the volatility (or risk) of a fund in comparison to that of its index or benchmark. A fund with a beta very close to 1 means the fund's performance closely matches the index or benchmark. A beta greater than 1 indicates greater volatility than the overall market, and a beta less than 1 indicates less volatility than the benchmark.
the book says that "all stocks in an efficient market are zero NPV investments". why is this true
in an efficient market there is such intense competition that all PV of investments offering high returns should have already been exploited... if case then all stocks are at true intrinsic value.. all stocks should be assumed to have 0 NPV. *in an efficient market, there should be no obvious opporutunity to earn extraordinary profit bc all relelvent useful information should have already been exploited and reflected in stock prices. all that is left is appropriate stock prices and corresponding risk related to them so appropriate npv of these stock prices should be zero.
Explain why all stocks should have a zero NPV in an efficient market?
in an efficient market, there should be no obvious opporutunity to earn extraordinary profit bc all relelvent useful information should have already been exploited and reflected in stock prices. all that is left is appropriate stock prices and corresponding risk related to them so appropriate npv of these stock prices should be zero. * if stock market is efficient and competition is intense, all extraordinary profits should have already been driven out fo the market place. doesnt mean they never occur, just means that they disappear quickly.
what is unsystematic risk and how can it be eliminated?
it is specific risk/diversifiable risk that comes with the company you are investing in. it can be eliminated through diversification. the process of allocating capital in a way that reduces exposure to one particular assert or risk. investing in a portfolio can reduce this risk. *market risk* random events that happen to the company - unique to the company. can be eliminated through diversification.
Explain what is meant by market efficiency?
it is the degree that information is available and how rapidly it reflects stock prices. ME suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.
According to EMH, its improbably that investors should be able to consistently "beat the market" why?
it is unlikely that even a professional can beat the market consistently based on skill. the performance is probably due to chance. this is bc in an efficient market, there is no obvious opportunity for extraordinary earnings and efficient markets have random prices changes and you cant predict the surprises that cause them. in general, market should be unpredictable. *bc its predicting the fture and people cant do that consistently .
If your financial advisor claims to have beaten the market for ten years straight, what do you think
it is unlikely that even a professional can beat the market consistently based on skill. the performance is probably due to chance. this is beacuase in an efficient market there is no obvious opportunity for extraordinary earnings and efficient markets have random prices changes and you cant predict the surprises that cause them. in general, market should be unpredictable. *get nervous bc market efficiency claims that is high unlikely. he may not be using the right benchmark. benchmark that claims you beat market but if your investment is higher risk you should be beating the market..this should not happen would be highly unlikely.
is leverage a good thing? discuss
leverage arises because of fixed debt services. since income is variable and leverage is fixed, it has the ability to amplify in both directions (aka you could amplify in the right way and get rich as **** but you could also lose a shit ton and be in "financial distress". could be good or bad bc it amplifies the range of possible outcomes ( losses and returns)
What does the security market line represent
that all stocks are fairly priced relative to risk . represents trade off. represents market equilibrium where all stocks are fairly priced relative to risk. The beta is thus the sensitivity of the investment to the market or current portfolio. It is the measure of the riskiness of a project. The security market line ("SML" or "characteristic line") graphs the systematic (or market) risk versus the return of the whole market at a certain time and shows all risky marketable securities. The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.
if apple announced record earnings and its stock price didnt go up in response, how could that be explained and waht does it say about the EMH
that the predicted earnings were already accounted for int eh stock price. confirmation of such earnings would not be reflected by a change in prices. the announcement was anticipated. EMH argues taht all valuable information should have already been exploited, so the current price already takes it into account ( it wasnt a surprise).
if Boeing's reward to risk ratio exceeds the market risk premium, what are the implications?
the stock is expected to return a greater amount that it should be. (high return) . stock is underpriced (above the SML) and there will be a high reward. we expect it to go up as a result. (profit opportunity)
why do bond prices go down if interest rates go up?
there is an inverse relationship between interest rates and the price of the bond. if interest rates go up, the price of the bond will fall becasue as interest rate drops there is a lower quantity demanded. to adjust for this the price must be lowered. *for the bond to remain competitive. all other cash flows are fixed.
discuss what diversification does and how it works
unsystematic risk is specific risk/diversifiable risk that comes with the company you are investing in. it can be eliminated thorough diversification. diversification is the process of allocating capital in a way that reduces exposure to one particular asset or risk(investing all capital in oil companies) . investing in a portfoilio can reduce this risk. it is whenyou add multiple investments into your protfoilio . if they do not have a strong correlation, you can eliminate risk.
explain the concept of financial risk ( what is it)
variability and returns when it comes to borrowing. amplification in returns as a result of borrowing.Financial risk is an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss.
why invest in a portfolio of stocks instead of just one?
when you invest in one stock you are accepting total risk. if you invest in a porfolio, can diversify risk through diversification. unsystematic risk is specific risk/diversificable risk that comes with the company you are investing in. it can be eliminated through diversification.Unsystematic risk, also known as "specific risk," "diversifiable risk" or "residual risk," is the type of uncertainty that comes with the company or industry you invest in. Unsystematic risk can be reduced through diversification. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. Modern portfolio theory says that portfolio variance can be reduced by choosing asset classes with a low or negative covariance, such as stocks and bonds. This type of diversification is used to reduce risk. the more unrelated/ negative covariance the stocks are within a portfoilio , the more diversified and the less unsystematic risk there is.
