BFM Exam 3

Ch. 11 Identify the factors that affect a stock portfolio's volatility and explain their effects.

-A stock portfolio has more volatility when its individual stock volatilities are high, other factors held constant. -In addition, a stock portfolio has more volatility when its individual stock returns are highly correlated, other factors held constant. -A stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because the stocks will not experience peaks and troughs simultaneously. -Some offsetting effects will occur, smoothing the returns of the portfolio over time.

Ch. 11 Describe the January effect

-Because many portfolio managers are evaluated over the calendar year, they tend to invest in riskier small stocks at the beginning of the year and shift to larger (more stable) companies near the end of the year to lock in their gains -This tendency places upward pressure on small stocks in January of every year, causing the so-called January effect.

Ch. 11 How do earnings surprises affect valuations of stocks?

-Favorable earnings surprises increase the values of stocks. -Negative earnings surprises decrease the values of stocks.

Ch. 11 Explain why investor sentiment can affect stock prices

-Investor sentiment represents the general mood of investors in the stock market. -Since the stock valuations reflect expectations, there are some periods in which the stock market performance is not highly correlated with existing economic conditions. -For example, stock prices may rise when the economy is weak if most investors expect that the economy will improve in the near future.

Ch. 11 Meaning and use of implied volatility

-Investors can derive the stock's implied standard deviation (ISD) from the stock option pricing model. -The premium on a call option for a stock is dependent on factors such as the relationship between the current stock price and the exercise (strike) price of the option, the number of days until the expiration date of the option, and the anticipated volatility of the stock price movements. -There is a formula for estimating the call option premium based on various factors. The actual values of these factors are known, except for the anticipated volatility. -However, by plugging in the actual option premium paid by investors for that specific stock, it is possible to derive the anticipated volatility level. -Participants may use this measurement as their own forecast of that specific stock's volatility.

Ch. 11 Why might SOX cause a reduction in the valuation of a stock?

-It may allow firms to detect problems that they would not have recognized otherwise, so that they can increase their cash inflows. -However, the costs of complying with SOX result in higher cash outflows.

Ch. 11 Explain how stock volatility changed during the credit crisis.

-Stock prices became much more volatile due to uncertainty about economic conditions. -The prices of some stocks were frequently changing by more than 5 percent on a single day.

Ch. 11 What are the risks of investing in stocks in emerging markets?

-Stocks in emerging markets are more exposed to major government turnover and other forms of political risk. -They also expose U.S. investors to a high degree of exchange rate risk because their local currencies are typically very volatile

Ch. 11 Use a stock valuation framework to explain why the Sarbanes-Oxley Act (SOX) could improve the valuation of a stock.

-The Sarbanes-Oxley Act of 2002 was intended to improve the reporting of financial statements

Ch. 11 Why can expectations of an acquisition affect the value of the target's stock?

-The expected acquisition of a firm typically results in an increased demand for the target's stock and therefore raises the stock price. -Investors recognize that the target's stock price will be bid up once the acquiring firm attempts to acquire the target's stock.

Ch. 11 Explain how to test weak-form efficiency in the stock market

-Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices -If future price movements can be predicted by assessing the past movements, a market inefficiency is detected

Ch. 11 Explain (using intuition instead of math) why stock prices may decrease in response to a higher risk-free rate according to the CAPM. In some periods, the risk-free rate rises in response to higher economic growth. Explain (using intuition instead of math) why stock prices may increase in this situation even though the risk-free rate increases

-When the risk-free rate rises, the required rate of return rises, and therefore expected cash flows generated by the stock are discounted at a higher discount rate, which results in a lower value. -If the economic growth increases, there may be an increase in expected cash flows. -This favorable effect can overwhelm the unfavorable effect of a rise in the discount rate used to discount cash flows

Ch. 11 Assume that the expected inflation rate has just been revised upward by the market. Would the required return by investors who invest in the stocks be affected?

-an increase in expected inflation can increase the risk-free interest rate, which is a key component of the required rate of return on stocks -so, it should cause an increase in the required rate of return on stocks.

Ch. 11 Explain why beta serves as a measure of the stock's risk.

-because it measures sensitivity to the market -the higher the sensitivity, the more likely that the stock will perform poorly under adverse market conditions.

Ch. 11 Explain the use of the price-earnings (PE) ratio for valuing a stock

-by applying the industry PE ratio to the firm's expected earnings for the next year -assumes that the growth in earnings in future years will be similar to that of the industry.

Ch. 11 Describe the value-at-risk method for measuring risk

-estimates the largest expected loss to a particular investment position for a specified confidence level. -It is intended to warn investors about the potential maximum loss that could occur. -If the investors are uncomfortable with the potential loss that could occur in a day or a week, they can revise their investment portfolio to make it less risky. -commonly used to measure the risk of a portfolio -Some stocks may be perceived to have high risk when assessed individually, but low risk when assessed as part of a portfolio -This is because the likelihood of a large loss in the portfolio is influenced by the probabilities of simultaneous losses in all of the component stocks for the period of concern.

Ch. 11 Explain how the value of the dollar affects stock valuations

-first, foreign investors tend to purchase U.S. stocks when the dollar is weak and sell them when it is near its peak. So, the foreign demand for any given U.S. stock may be higher when the dollar is expected to strengthen, other things being equal. -also, stock prices are affected by the impact of the dollar's changing value on cash flows. -Stock prices of U.S. firms primarily involved in exporting could be favorably affected by a weak dollar and adversely affected by a strong dollar. -U.S. importing firms could be affected in the opposite manner. -Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. -A multinational corporation's consolidated reported earnings will be affected by exchange rate fluctuations even if the company's cash flows are not affected. -A weaker dollar tends to inflate the reported earnings of a U.S.-based company's foreign subsidiaries. -Some analysts argue that any effect of exchange rate movements on financial statements is irrelevant unless cash flows are also affected. -The changing value of the dollar can also affect stock prices by affecting expectations of economic factors that influence the firm's performance. For example, if a weak dollar stimulates the U.S. economy, it may enhance the value of a U.S. firm whose sales are dependent on the U.S. economy. -A strong dollar could adversely affect such a firm if it dampens U.S. economic growth. -Because inflation affects some firms, a weak dollar value could indirectly affect a firm's stock by putting upward pressure on inflation. -A strong dollar would have the opposite indirect impact.

Ch. 11 How are the interest rate, the required rate of return on a stock, and the valuation of a stock related?

-given a choice of risk-free Treasury securities or stocks, stocks should be purchased only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate -the relation between interest rates and stock prices is not constant over time -however, most of the largest stock market declines have occurred in periods when interest rates increased substantially. -the stock market's rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities (with low rates) to equity securities.

Ch. 11 What are some limitations of the dividend discount model?

-may result in an inaccurate valuation of a firm because of potential errors in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors -are more pronounced when valuing firms that retain most of their earnings rather than distribute them as dividends, because the model relies on the dividend as the base for applying the growth rate

Ch. 11 dividend discount valuation model

-measures the value of a firm as the present value of future expected dividends to be received by the investor -can account for uncertainty by allowing dividends to be revised in response to revised expectations about a firm's cash flows, or by allowing the required rate of return to be revised in response to changes in the required rate of return by investors.

Ch. 11 Explain how to estimate the beta of a stock

-the beta of a stock can be estimated by obtaining returns of the firm and the stock market over the last 12 quarters and applying regression analysis to derive the slope coefficient

Ch. 11 Explain how economic growth affects the valuation of a stock

-the firm's value should reflect the present value of its future cash flows. -because earnings are a primary component of corporate cash flows, many investors use forecasted earnings to determine whether a firm's stock is over- or undervalued.

Ch. 11 Why might investors derive different valuations for a stock when using the price-earnings method?

-this method has several variations, which can result in different valuations -investors may use different forecasts for the firm's earnings or the mean industry earnings over the next year. The previous year's earnings are often used as a base for forecasting future earnings, but the recent year's earnings do not always provide an accurate forecast of the future -A second reason for different valuations when using the PE method is that investors disagree on the proper measure of earnings. Some investors prefer to us operating earnings, or exclude some unusually high expenses that result from one-time events -A third reason is that investors may disagree on the firms that should represent the industry norm. Some investors use a narrow industry composite composed of firms that are very similar (in terms of size, lines of business, etc.) to the firm being valued; other investors prefer a broad industry composite -even if investors agree on a firm's forecasted earnings, they may still derive different values for that firm as a result of applying different PE ratios. Furthermore, even if investors agree on the firms to include, they may disagree on how to weight each firm.

Ch. 11 semistrong-form efficiency

suggests that security prices reflect all publicly traded information.

Ch. 11 strong-form efficiency

suggests that security prices reflect public and private information

Ch. 11 weak-form efficiency

suggests that security prices reflect recent price movements and trading information