investments exam two

investor assumptions of CAPM

-investors plan for the same (single period) horizon -investors are efficient users of analytical methods: investors have homogeneous expectations -investors are rational, mean variance optimizers

risk premium

expected return in excess if that on risk free securities

fundamental analysis EMH

-research on determinants of stock value i.e. earnings, dividend prospects, future interest expectations, and firm risk -assumes stock price is equal to discounted value of expected future cash flow

technical analysis EMH

-research on recurrent and predictable price patterns and on proxies for buy/ sell pressure in market -resistance level: unlikely for stock/ index to rise above -support level: unlikely for stock/ index to fall below

implications of CAPM

-security risk premiums will be proportional to B -all investors choose the same portfolio -active vs. passive investment strategy

market risk

-systematic/ nondiversifiable risk -a risk common to the whole economy -cannot be diversified away

implications of EMH

-technical analysis -fundamental analysis -active vs passive management

three rules of two risk asset portfolios

1. ROR 2. ERR 3. variance of ROR

geometric return

single per-period return -gives same cumulative performance as sequence of actual returns -compound period-by-period returns; find per-period rate that compounds to the same value

standard deviation

square root of variance

weak form EMH

stock prices already reflect all information contained in history of trading -prices, trading volume

semi strong form EMH

stock prices already reflect all public information

strong form EMH

stock prices already reflect all relevant information, including inside information

alpha

stock's expected return beyond that induced by market index

arithmic return

sum of returns in each period divided by the number of periods

In the context of the capital asset pricing model, the systematic measure of risk is captured by _________.

B

market assumptions of CAPM

-all investors are price takers -all information relevant to security analysis is free and publicly available -all securities are publicly owned and traded -no taxes on investment returns -no transaction costs -lending and borrowing at the same risk free rate are unlimited

optimal portfolio

-expand asset choices to include risk-free asset -then resulting opportunity set is also the CAL -CAL with the highest Sharpe ratio gives the best opportunity set -this line is tangent to the investment opportunity set of risky assets as the optimal risky portfolio -optimal risky portfolio has the highest Sharpe ratio -all investors will choose the same optimal portfolio regardless of their risk aversion -based on their risk aversion they choose different combinations of risk free assets and optimal portfolio

unique / firm specific risk

-nonsystematic / diversifiable risk -risk that can be estimated by diversification

efficient marketing hypothesis

-prices of securities fully reflect all relevant information -weak form EMH -semi strong form EMH -strong form EMH

If enough investors decide to purchase stocks, they are likely to drive up stock prices, thereby causing _____________ and ___________. A. expected returns to fall; risk premiums to fall B. expected returns to rise; risk premiums to fall C. expected returns to rise; risk premiums to rise D. expected returns to fall; risk premiums to rise

A

32. Security X has an expected rate of return of 13% and a beta of 1.15. The risk -free rate is 5%, and the market expected rate of return is 15%. According to the capital asset pricing model, security X is _________. A. fairly priced B. overpriced C. underpriced D. none of these answers

B

Security A has an expected rate of return of 12% and a beta of 1.1. The market expected rate of return is 8%, and the risk -free rate is 5%. The alpha of the stock is _________. A. -1.7% B. 3.7% C. 5.5% D. 8.7%

B

According to the capital asset pricing model, a security with a _________. A. negative alpha is considered a good buy B. positive alpha is considered overpriced C. positive alpha is considered underpriced D. zero alpha is considered a good buy

C

Consider the capital asset pricing model. The market degree of risk aversion, A, is 3. The variance of return on the market portfolio is .0225. If the risk- free rate of return is 4%, the expected return on the market portfolio is _________. A. 6.75% B. 9% C. 10.75% D. 12%

C

Consider two stocks, A and B. Stock A has an expected return of 10% and a beta of 1.2. Stock B has an expected return of 14% and a beta of 1.8. The expected market rate of return is 9% and the risk -free rate is 5%. Security __________ would be considered the better buy because_________. A. A; it offers an expected excess return of .2% B. A; it offers an expected excess return of 2.2% C. B; it offers an expected excess return of 1.8% D. B; it offers an expected return of 2.4%

C

If all investors become more risk averse, the SML will _______________ and stock prices will _______________. A. shift upward; rise B. shift downward; fall C. have the same intercept with a steeper slope; fall D. have the same intercept with a flatter slope; rise

C

The graph of the relationship between expected return and beta in the CAPM context is called the _________. A. CML B. CAL C. SML D. SCL

C

You invest $600 in security A with a beta of 1.5 and $400 in security B with a beta of .90. The beta of this portfolio is _________. A. 1.14 B. 1.2 C. 1.26 D. 1.5

C

According to the capital asset pricing model, fairly priced securities have _________. A. negative betas B. positive alphas C. positive betas D. zero alphas

D

The market portfolio has a beta of _________. A. -1 B. 0 C. 0.5 D. 1

D

When all investors analyze securities in the same way and share the same economic view of the world, we say they have ____________________. A. heterogeneous expectations B. equal risk aversion C. asymmetric information D. homogeneous expectations

D

Which of the following are assumptions of the simple CAPM model? I. Individual trades of investors do not affect a stock's price. II. All investors plan for one identical holding period. III. All investors analyze securities in the same way and share the same economic view of the world. IV. All investors have the same level of risk aversion.

I, II, and III only

investment opportunity set

a set of available portfolio risk-return combinations -allocation between risky assets: risk-return trade-off -mean variance criterion: 1. if expected return of A is greater than B and standard deviation of A is less than B then A dominates B 2. all investors will prefer A to B 3. in the graph, A will be northwest to B

Are the following true or false? Explain. A. Stocks with a beta of zero offer an expected rate of return of zero. B. The CAPM implies that investors require a higher return to hold highly volatile securities. C. You can construct a portfolio with a beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio.

a- false b- true c- false

positive-alpha stock

abnormal rate of return on security in excess of that predicted by equilibrium model (CAPM)

capital market line

capital allocation line using market index portfolio as risky asset passive investment strategy allocates portfolio on CML -does not require security analysis -inexpensive and simple -S&P 500 -gaining in popularity

mean variance analysis

evaluating portfolios according to their expected returns and standard deviations

variance

expected value of squared deviation from mean

efficient frontier

graph representing a set of portfolios that maximizes the expected return at each level of portfolio risk -expected returns are estimated based on fundamental analysis variances and covariances are estimated using historical data

seperation property

implies portfolio choice can be separated into two independent tasks: 1. determination of optimal risky portfolio (purely technical problem) 2. personal choice of best mix of risky portfolio and risk-free asset (depends on individual's risk aversion)

random walk

indicates well functioning-markets, not irrational ones -only new information will cause the change in stock price -notion that stock price changes are random

dollar weighted average return

internal rate of return on investment

expected return

mean value of distribution of HPR

value at risk

measure of downside risk -the worst loss that will be suffered with a given probability -often 1% or 5%

active vs passive portfolio management EMH

passive investment strategy: -buying well diversified portfolio without attempting to find misplaces securities -index fund -mutual fund which holds shares in proportion to market index representation

scenario analysis

possible economic scenarios -specify likelihood and HPR -derived from history of returns

probability distribution

possible outcomes with probabilities

excess return

rate of return in excess of that on risk free rate

holding period return

rate of return over given investment period

risk free rate

rate of return that can be earned with certainty

Sharpe ratio

ratio of portfolio risk premium to standard deviation -reward-to-voliatility

price of risk

ratio of risk premium to variance

index model

relates stock returns to returns on broad market index firm-specific factors

risk aversion

reluctance to accept risk

security market line (SML)

represents expected return-beta relationship of CAPM -graphs individual asset risk premiums as functions of asset risk

beta

sensitivity of security's return to market factor