Business Finance Chapter 10 & 11
Variance
"plural" can use to measure on portfolios
The capital gains yield =
(Pt+1 - Pt)/Pt
Geometric average
- Average compound return per period over multiple periods - Answers the question: "What was your average compound return per year over a particular period?" - compounding affect
risk-free rate
- rate of return on a riskless investment - treasury bills are considered risk-free
Which of the following are examples of systematic risk?
- regulatory changes in tax rates - future rates of inflation
The Ibbotson SBBI data show that over the long-term, ___.
- small-company stocks generated the highest average return - T-bills, which had the lowest risk, generated the lowest return - small-company stocks had the highest risk level
Which of the following are needed to describe the distribution of stock returns?
- the mean return - the standard deviation of returns
two key lessons from capital market history
- there is a reward for bering risk - the greater the potential reward, the greater the risk
Some important characteristics of the normal distribution are that it is:
-bell shaped - symmetrical
Arrange the following investments starting from lowest historical risk premium to highest historical risk premium.
1. US treasury bond 2. Long-term corporate bonds 3. Large- company bonds 4. small- company bonds
t-bill rate risk free?
1.) based on historical data (see graphs on slides) there are no negative 2.) it follows the inflation rate and so can always rely on return from inflation
A dividend yield of 10% says that, for each dollar we invest, we get ____________, cents in dividends.
10
With a normal distribution, the probability that we end up with having two standard deviations is about _______ percent.
95
% return
= $ return / $ invested
What is the equation for the capital asset pricing model? (CAPM)
Expected return on security = Risk-free rate + Beta × (Return on market - Risk-free rate)
True or false: Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio increases.
False: Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio declines.
True or false: Portfolio weights can be defined as the dollars invested in each asset.
False: It is the percentage of dollars invested in each asset.
True or false: The surprise part of any announcement is the information the market uses to form the expectation of the return on the stock.
False: The surprise is the news that influences the unanticipated return on the stock.
What does the security market line depict?
It is a graphical depiction of the capital asset pricing model.
_______________ and _____________ conducted a famous set of studies dealing with rates of return in U.S. financial markets.
Roger Ibbotson and Rex Sinquefield
Which of the following types of risk is not reduced by diversification?
Systematic, or market risk
Which of the following is commonly used to measure inflation?
The Consumer Price Index (CPI)
To determine the appropriate required return for an investment, we can use _____________________.
The Security Market Line (SML)
What is the intercept of the security market line (SML)?
The risk-free rate
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?
The risk-free rate of return Risk-free rate + 0 × Market risk premium = Risk-free rate
Suppose a stock had an initial price of $61 per share, paid a dividend of $1.40 per share during the year, and had an ending share price of $69. Compute the percentage total return. What was the dividend yield? The capital gains yield?
Total rate of return= dividend yield + capital gain yield R = DY + CGY = D1+P1-P0/p0 = (1.40 +69 -61)/61 + 0.1541 or 15.41% Dividend yield = D1/P0 + 1.40/61 = 0.0230 or 2.3% Capital gain yield = P1-P0/P0 = (69-61)/61 = 13.11%
True or false: Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.
True: Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.
More volatility in returns produces ______ difference between the arithmetic and geometric averages
a larger
The calculation of a portfolio beta is similar to the calculation of:
a portfolios expected return
Match each information type to the form of market efficiency that identifies that type of information as being quickly and accurately reflected in stock prices.
all info: strong form efficiency all public info: semi- strong efficiency historical stock prices: weak form efficiency
In an efficient market ______ investments have a _____ NPV.
all; zero
When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market:
already knew about most of the news item
The ________ price index is a commonly used measure of inflation
consumer
The appropriate discount rate to use to evaluate a new project is the _____.
cost of capital
The minimum required return on a new project is known as the:
cost of capital The internal rate of return is the discount rate that sets NPV to zero, but it is not necessarily the minimum required return on the project. That is set by the riskiness of the project itself.
capital gain yield=
dividend yield + capital gain yield
The ______ return on a portfolio is a combination of the expected returns on the assets in the portfolio.
expected
True or false: Arithmetic and geometric averages are useful because they are not influenced by volatility.
false: More volatility in returns produces a greater difference between the arithmetic and geometric averages
In 2008, the prices on long-term U.S. Treasury bonds __________ .
gained 40%
The risk-return relationship states that a riskier investment should demand a ____________ return.
higher
An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk.
less than
What is the slope of the security market line (SML)?
market-risk premium
To get the average, or ____________, the yearly returns are summed and then divided by the number of returns.
mean
Systematic risk will ____ when securities are added to a portfolio.
not change
If you use an arithmetic average to project long-run wealth levels, your results will most likely be _______.
optimistic
Which type of stock price adjustment time path occurs when there is a bubble (price run up) in the path followed by a decline after the market receives information about the stock?
overreaction and correction
If you use a geometric average to project short-run wealth levels, your results will most likely be _______ .
pessimistic
The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.
positive
normally an excess rate return is
positive
The risk ____________ can be interpreted as the reward for bearing risk.
premium
The _____ is the news that influences the unanticipated return on the stock.
surprise
Beta tells us the amount of ________ risk of an asset or portfolio relative to ______.
systematic; an average risky asset
Even if the portfolio is well diversified, the investor is still exposed to _____ risk.
systemic
The return expected on an investment depends only on the asset's _____ risk.
systemic
The systematic risk principle argues that the market does not reward risks:
that are borne unnecessarily that are diversifiable
True or false: It is possible for the unsystematic risk of a portfolio to be reduced almost to zero.
true
If a study of past stock prices and volume to find mis-priced securities will not lead to gains in the market, then the market must be at least _____ efficient.
weak-form
What is the beta of the risk-free asset?
zero
What are the two components of risky return (U) in the total return equation?
- Market risk - Unsystemic risk U = m + ε
EMH does mean that:
- On average, you will earn a return appropriate for the risk undertaken. - There is no bias in prices that can be exploited to earn excess returns. - Market efficiency will not protect you from wrong choices if you do not diversify —you still don't want to put all your eggs in one basket. 10-42
Arithmetic average
- Return earned in an average period over multiple periods - Answers the question: "What was your return in an average year over a particular period?" - no compound
The Efficient Market Hypothesis:
- Stock prices are in equilibrium. - Stocks are "fairly" priced. - Informational efficiency
Which of the following are true based on the year-to-year returns from 1926-2014?
- T-bills sometimes outperform common stocks. - Common stocks frequently experience negative returns.
The CAPM shows that the expected return for an asset depends on which three things?
- The amount of systematic risk - The reward for bearing systematic risk - The pure time value of money
Which of the following statements is (are) true about variance?
- Variance is a measure of the squared deviations of a security's return from its expected return. - Standard deviation is the square root of variance.
Percentage returns are more convenient than dollar returns because they:
- apply to any amount invested - allow comparison against other investments
What two factors determine a stock's total return?
- expected return - unexpected return
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
- it may eventually be almost totally eliminated - it is likely to decrease
Which of the following are examples of unsystematic risk?
- labor strikes - An increase in competition in the industry - changes in management
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:
- positive - risk premium: difference between the return on a risky investment and that on a risk-free investment, and we calculate the historical risk premiums on some different investments - If investors are averse to risk, they will demand higher returns from the market, thereby meaning that the risk premium will be positive (greater than zero).
Which of the following are examples of information that may impact the risky return of a stock?
-The Fed's decision on interest rates at their meeting next week - The outcome of an application currently pending with the Food and Drug Administration.
risk premium
-the excess return required from an investment in a risky asset over that required from a risk-free investment -reward for bearing risk
By definition, what is the beta of the average asset equal to?
1
The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step.
1. Calculate the expected return 2. calculate the deviation of each return from the expected return 3. square each deviation 4. calculate the average squared deviation
The probability of an outcome being at least 2 standard deviations below the mean in a normal distribution is approximately:
2.5%
In 2008, the S&P 500 plunged
37%
What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4 percent and the expected return on the market is 12 percent?
4% + 1.2(12% - 4%) = 13.6%
The probability of a return being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent.
68
From 1900 to 2010, the average stock market risk premium of the U.S. was ______.
7.2% ranked 7th of all countries
If the arithmetic average return is 10% and the variance of returns is 0.05, find the approximate geometric mean.
7.5%
$ return
= dividends + capital gains
capital gains
= price received - price paid
total present return
= the return on an investment measured as a percentage of the original investment
total dollar return
= the return on an investment measured in dollars
______ risk is reduced as more securities are added to the portfolio
Diversifiable Unsystematic Company-specific
You invest in a stock with a share price of $25. After one year, the stock price per share is $35. Each share paid a $2 dividend. What was your total return?
Dollars Percent Dividends $2 $2/25=8% Capital Gain $35-$25=$10 $10/25=40% Total Return $2 + $10= $12 $12/25 = 48%
The dividend yield =
Dt+1/Pt
What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5?
Expected return for a security= 5 + 1.5 x (9 - 5) = 11%
True or false: Discounting a news item is the same as taking the present value of that item.
False: When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market already new about most of the news item.
systemic risk
It is a risk that pertains to a large number of assets. - aka market risk
Standard Deviation
Use on individual stocks but cannot use on portfolio
What is the Reward-to-Risk Ratio?
[E(RA) - Rf]/βA
The dividend yield for a one-year period is equal to the annual dividend amount divided by the ____
beginning stock price
The CAPM can also be used for a portfolio by first determining the portfolio's
beta
_______ were a bright spot for U.S. investors during 2008.
bonds
The percentage change in the price of a stock over a period of time is called its ___________.
capital gain yield
When a company declares a dividend, shareholders generally receive ____.
cash
The average return on the stock market can be used to ___.
compare stock returns with the returns on other securities
The geometric average return is the average _____________ return earned per year over a multiyear period.
compound
True or false: Percentage returns are difficult to use for comparisons because they depend on the dollar amount invested.
false
Dividends are the ______ component of the total return from investing in a stock.
income
The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the:
initial stock price
Efficient markets DO NOT imply that
investors cannot earn a positive return in the stock market.
If the dispersion of returns on a particular security is very spread out from the security's mean return, the security ____.
is highly risky
The arithmetic average rate of return measures the ____.
return in an average year over a given period
If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______.
risk premium; systematic risk
Unsystemic Risk
risk that affects a single asset or a small group of assets - unique or asset- specific risks
Geometric average < arithmetic average unless all the returns are equal
subtract half of the variance from the Arithmetic average you should get the geometric average
The geometric average rate of return is approximately equal to ___.
the arithmetic mean minus half of the variance
A portfolio can be described by its portfolio weights which are defined as ____________
the percentage of dollars invested in each asset
standard deviation
the square root of the variance
How are the unsystematic risks of two different companies in two different industries related?
there is no relationship
The normal distribution is completely described by the average and standard deviation.
true
True or false: According to the capital asset pricing model (CAPM), the risk-free rate of return is the expected return on a security with a beta of zero.
true
The efficient markets hypothesis contends that _____________ capital markets such as the NYSE are efficient.
well-organized