Financial Management, Mid-term review, Chapter 6

If a company's beta were to double, would its expected return double?

According to the Security Market Line (SML) equation, an increase in beta will increase a company's expected return by an amount equal to the market risk premium times the change in beta. For example, assume that the risk-free rate is 6 percent, and the market risk premium is 5 percent. If the company's beta doubles from 0.8 to 1.6 its expected return increases from 10 percent to 14 percent. Therefore, in general, a company's expected return will not double when its beta doubles.

Continuous probability distribution

A continuous probability distribution contains an infinite number of outcomes and is graphed from negative infinity to positive infinity.

Probability distribution and its relation to risk

A probability distribution is a listing, chart or graph of all possible outcomes, such as expected rates of return, with a probability assigned to each outcome. When in graph form, the tighter the probability distribution, the less uncertain the outcome.

Risk aversion; realized rate of return

A risk averse investor dislikes risk and requires a higher rate of return as an inducement to buy riskier securities. A realized return is the actual return an investor receives on their investment. It can be quite different than their expected return.

Risk premium for Stock I, RPi; market risk premium, RPm

A risk premium is the difference between the rate of return on a risk-free asset and the expected return on Stock i which has higher risk. The market risk premium is the difference between the expected return on the market and the risk-free rate.

Capital Asset Pricing Model (CAPM)

CAPM is a model based upon the proposition that any stock's required rate of return is equal to the risk free rate of return plus a risk premium reflecting only the risk remaining after diversification.

Correlation as a concept; correlation as a coefficient, p

Correlation is the tendency of two variables to move together. A correlation coefficient (ρ) of +1.0 means that the two variables move up and down in perfect synchronization, while a coefficient of -1.0 means the variables always move in opposite directions. A correlation coefficient of zero suggests that the two variables are not related to one another; that is, they are independent.

Equilibrium

Equilibrium is the condition under which the expected return on a security is just equal to its required return, = r, and the market price is equal to the intrinsic value.

Three forms of EMH

Financial theorists generally define three forms of market efficiency: weak-form, semistrong-form, and strong-form. Weak-form efficiency assumes that all information contained in past price movements is fully reflected in current market prices. Thus, information about recent trends in a stock's price is of no use in selecting a stock. Semistrong-form efficiency states that current market prices reflect all publicly available information. Therefore, the only way to gain abnormal returns on a stock is to possess inside information about the company's stock. Strong-form efficiency assumes that all information pertaining to a stock, whether public or inside information, is reflected in current market prices. Thus, no investors would be able to earn abnormal returns in the stock market.

Market risk; diversifiable risk; relevant risk

Market risk is that part of a security's total risk that cannot be eliminated by diversification. It is measured by the beta coefficient. Diversifiable risk is also known as company specific risk, that part of a security's total risk associated with random events not affecting the market as a whole. This risk can be eliminated by proper diversification. The relevant risk of a stock is its contribution to the riskiness of a well-diversified portfolio.

Behavioral finance; herding; anchoring

Most people don't behave rationally in all aspects of their personal lives, and behavioral finance assumes that investors have the same types of psychological behaviors in their financial lives as in their personal lives. Anchoring bias is the human tendency to "anchor" too closely on recent events when predicting future events. Herding is the tendency of investors to follow the crowd. When combined with overconfidence, anchoring and herding can contribute to market bubbles.

Risk in general, stand alone risk

Stand-alone risk is only a part of total risk and pertains to the risk an investor takes by holding only one asset. Risk is the chance that some unfavorable event will occur. For instance, the risk of an asset is essentially the chance that the asset's cash flows will be unfavorable or less than expected.

Efficient Markets Hypothesis (EMH)

The Efficient Markets Hypothesis (EMH) states (1) that stocks are always in equilibrium and (2) that it is impossible for an investor to consistently "beat the market." In essence, the theory holds that the price of a stock will adjust almost immediately in response to any new developments. In other words, the EMH assumes that all important information regarding a stock is reflected in the price of that stock.

Fama-French three-factor model

The Fama-French 3-factor model has one factor for the excess market return (the market return minus the risk free rate), a second factor for size (defined as the return on a portfolio of small firms minus the return on a portfolio of big firms), and a third factor for the book-to-market effect (defined as the return on a portfolio of firms with a high book-to-market ratio minus the return on a portfolio of firms with a low book-to-market ratio).

Beta coefficient,, b; average stock's beta

The beta coefficient is a measure of a stock's market risk, A stock with a beta greater than 1 has stock returns that tend to be higher than the market when the market is up but tend to be below the market when the market is down. The opposite is true for a stock with a beta less than 1..

Expected rate of return (r hat)

The expected rate of return (r^ ) is the expected value of a probability distribution of expected returns.

Expected return on a portfolio; market portfolio

The expected return on a portfolio is simply the weighted-average expected return of the individual stocks in the portfolio, with the weights being the fraction of total portfolio value invested in each stock. The market portfolio is a portfolio consisting of all stocks.

Security Market Line (SML); SML Equation

The security market line (SML) represents in a graphical form, the relationship between the risk of an asset as measured by its beta and the required rates of return for individual securities. The SML equation is essentially the CAPM, ri = rRF + bi(RPM). It can also be written in terms of the required market return: ri = rRF + bi(rM - rRF).

Slope of SML and its relationship to risk aversion

The slope of the SML equation is (rM - rRF), the market risk premium. The slope of the SML reflects the degree of risk aversion in the economy. The greater the average investors aversion to risk, then the steeper the slope, the higher the risk premium for all stocks, and the higher the required return.

Standard deviation, variance

The standard deviation (σ) is a statistical measure of the variability of a set of observations. The variance (σ2) of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation.