FIN 3303 Ch 3
variance
-represents dispersion of a given distribution -natural measure of risk
Nothing
According to CAPM, what is the reward that investors receive for bearing idosyncratic risk A. Beta B. The risk-free rate C. Nothing D. The market risk premium
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Actual returns are predictable (at least risk premium) and excess returns are unpredictable
the discounted value of expected cash flows
Efficient market securities are priced as?
F
Excess returns are predictable and actual returns are unpredictable
F
If the market exhibited weak form efficiency, trading strategies that were based on past price patterns (eg candlestick charts) would be profitable
Efficient markets allow: -one to rely on market prices to guide decisions -rely on market data when markets are efficient -
List some reasons why financial managers care if markets are efficient
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Market risk premium is independent of stock betas
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Prices don't reflect private information
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T/F: . If markets are, in fact, efficient, the market price is the best estimate of value, and the process of valuation becomes one of justifying the market price is categorized as an alternative view
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T/F: A weight for each asset is a fraction of portfolio held in that asset
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T/F: According to CAPM, investors get rewarded only for taking idiosyncratic risk
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T/F: According to CAPM, investors get rewarded only for taking systematic risk
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T/F: According to risk-return tradeoff, large stocks (individual) have lower volatility
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T/F: An efficient market is one where the market price is a biased estimate
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T/F: An efficient market is one where the market price is an unbiased estimate (true value value of the estimate)
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T/F: An efficient market would carry negative implications for many investment strategies and actions that are taken for granted
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T/F: Combining stocks to form a well-diversified utility portfolio eliminates all volatility
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T/F: Correlation ranges from -1 & +1
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T/F: Diversification eliminates idiosyncratic risk, but not systematic risk
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T/F: Diversification eliminates systematic risk, but not idiosyncratic risk
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T/F: Diversified investor would continue buying stock until EXPECTED RETURN only represents compensation for SYSTEMATIC RISK
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T/F: Efficient market securities are priced as the discounted value of expected cash flows
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T/F: Efficient markets are characterized by quick and accurate incorporation of new information
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T/F: Efficient markets essentially simplify the lives of financial decisions makers
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T/F: Even the largest of individual stock has higher volatility than portfolio of large stocks
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T/F: For capital budgeting decisions we do not need risk free rates and risk premiums
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T/F: For capital budgeting decisions we need risk free rates and risk premiums.
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T/F: Higher variance (or standard deviation) represents greater dispersion, hence, greater risk
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T/F: Holding returns constant, individual stocks less volatile
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T/F: Holding returns constant, individual stocks more volatile
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T/F: If financial markets are efficient, then firms can always raise capital for positive NPV investments.
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T/F: If financial markets are efficient, then firms can never raise capital for positive NPV investments
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T/F: If markets are not efficient, the market price may deviate from the true value, and the process of valuation is directed towards obtaining a reasonable estimate of this value is categorized as an alternative view
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T/F: If markets were, in fact, efficient, investors WOULD STOP looking for inefficiencies, which would lead to markets becoming inefficient again
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T/F: If markets were, in fact, efficient, investors would look for inefficiencies, which would lead to markets becoming efficient again
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T/F: If price changes are NOT quick and/or accurate there may be opportunity to profit
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T/F: If price changes are quick and/or accurate there may be opportunity to profit
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T/F: If you believe that markets are inefficient, you will (write on board): focus your energy on valuing assets in markets which you believe are most likely to have inefficiencies. 2. pick a valuation approach that is consistent with what form of inefficiency you see in markets.
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T/F: If you believed that markets were efficient, you would work hard to ensure that the value from your model converges on the market price (which is the best estimate of value in an efficient market)
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T/F: If your believed markets were inefficient you would work hard to ensure that the value from your model converges on the market price (which is the best estimate of value in an efficient market)
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T/F: In an efficient market, a strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy, that created larger information and execution costs
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T/F: In an efficient market, the expected returns from any investment will be consistent with the risk of that investment over the long term, though there may be deviations from these expected returns in the short term
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T/F: In an efficient market, the purchase or sale of a security at the prevailing market prices is NEVER a positive NPV transaction
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T/F: In an efficient market, the purchase or sale of a security at the prevailing market prices is a positive NPV transaction
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T/F: In competitive markets, asset's EXPECTED RETURN should be directly related to it systematic risk
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T/F: In low transaction cost/liquid markets (large stocks, U.S. government bonds), there are very, very few arbitrage opportunities.
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T/F: In the presence of market frictions, financial markets do not work perfectly -- and therefore financial decisions have consequences
F
T/F: Individual stock exhibit a linear risk-return relationship; and portfolios do not
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T/F: Individual stock have higher returns &/or lower volatility than portfolios
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T/F: Individual stock have lower returns &/or higher volatility than portfolios
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T/F: Investors are NOT compensated (with expected return) for bearing IDIOSYNCRATIC RISK
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T/F: Investors are also concerned with extent to which a stock's return is correlated with return of all other stocks (financial assets) because of diversification
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T/F: Investors tend to hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase
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T/F: Market 'in- efficiency' provide the basis for screening the universe of stocks to come up with a sub-sample that is more likely to have under valued stocks: Saves time for the analyst; Increases the odds significantly of finding under and over valued stocks.
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T/F: Market Price refers to information content of stock prices
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T/F: Market efficiency DOES NOT require the market price to be equal to the true value at every point in time
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T/F: Market efficiency DOES require the market price to be equal to the true value at every point in time
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T/F: Market efficiency does imply that simple trading rules do not work (NPV=0)
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T/F: Market efficiency does not imply that active investment strategy is dominated by passive one
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T/F: Market efficiency does not imply that investors are always rational
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T/F: Market efficiency does not imply that markets are always accurate
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T/F: Market efficiency implies that NO ONE can beat market in the short or long term
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T/F: Market efficiency implies that active investment strategy is dominated by passive one
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T/F: Market efficiency implies that investors are always rational
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T/F: Market efficiency implies that markets are always accurate
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T/F: Market efficiency implies that no one can beat market in the short or long term
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T/F: Market efficiency implies that one can beat market in the short or long term
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T/F: Market efficiency implies that return is predictable, risk adjusted returns are not
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T/F: Market efficiency implies that return risk adjusted returns are predictable, and return is not
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T/F: Market efficiency implies that simple trading rules work
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T/F: Market efficiency implies that stock prices cannot deviate from true values
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T/F: Market efficiency refers to information content of stock prices
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T/F: Market efficiency requires that errors in market price be BIASED, price can be greater or less than true value (as long as deviations are random)
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T/F: Market efficiency requires that errors in market price be UNBIASED, prices can be greater or less than true value (as long as deviations are random)
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T/F: Market values for the weights of the assets in the portfolio are important because market values are forward
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T/F: Markets may not be perfectly competitive. ***When security transactions are zero NPV investments, then investors receive only their required rate of return. This is true only in competitive markets
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T/F: Most studies suggest that losses are twice as powerful, psychologically, as gains
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T/F: Plot portfolio standard deviation as a function of a number of securities in portfolio
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T/F: Portfolio volatility is a linear average of individual assets volatilities
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T/F: Portfolio volatility is not a linear average of individual assets volatilities
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T/F: Portfolios exhibit a linear risk-return relationship; and individual stock do not
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T/F: Portfolios have higher risk than their components
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T/F: Portfolios have lower risk than their components
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T/F: Predictable raw returns do not imply that markets are inefficient.
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T/F: Prices reflect private information
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T/F: Randomness implies that that there is an equal chance that stocks are under or over valued at any point in time.
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T/F: Reported prices may not be trade-able price, for example, In less liquid markets you can find profitable strategies -- which are not able to be implemented
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T/F: Securities priced as the discounted value of expected future cash flow (unbiased, i.e. correct on average).
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T/F: Since security issues are always a zero NPV transaction, they never distort the firm's investment decisions
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T/F: Since security issues are never a zero NPV transaction, they always distort the firm's investment decisions
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T/F: Slope of line, which measures relative volatility, is defined as stock beta, 𝛽.
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T/F: Stock Volatility refers to the variance of a stock's returns
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T/F: Stock volatility refers to the standard deviation of a stock's returns
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T/F: Stock volatility refers to the variance of a stock's return
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T/F: Symmetric distribution is characterized by means and standard deviation
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T/F: Systematic risk is risk that cannot be diversified
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T/F: The correlation between two stock's returns could be smaller than -1
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T/F: The covariance between two stocks ' returns could not be smaller than -1
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T/F: The covariance between two stocks' returns could not be smaller than -1 and could not be greater than +1
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T/F: The efficient market hypothesis does not say that all financial markets are efficient all of the time
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T/F: The efficient market hypothesis implies that excess returns are NOT predictable.
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T/F: The efficient market hypothesis implies that excess returns are predictable
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T/F: The efficient markets hypothesis implies that the market interprets news (dividend announcements, death of the founder) correctly on average
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T/F: The foreign currency market is a good candidate for a potentially inefficient market
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T/F: The odds of finding an undervalued stock should be random
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T/F: The reward per unit of systematic risk (ie price per the unit of systematic risk) is market risk premium
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T/F: The stock price should represent the unbiased assessment of success versus failure, so you can back-out the market's expectation of success.
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T/F: There exists a range around the efficient price in which the stock could reasonably be priced.
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T/F: This market contains well capitalized traders who care more about their reputation, than about losing money -- Central Banks.
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T/F: Two stocks with same beta must have same expected return and volatility.
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T/F: Volatility (standard deviation) and beta are measured in different units (standard deviation is measured in % and beta is unitless).
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T/F: Volatility captures BOTH systematic and idiosyncratic risk
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T/F: Volatility captures only idiosyncratic risk
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T/F: Volatility captures only systematic risk
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T/F: Volatility of individual stock is unrelated to expected returns
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T/F: When estimating beta, find line of best fit between returns of stock on Y (vertical) axis & returns on market portfolio plotted on X (horizontal) axis
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T/F: When markets are not competitive, rates of return may exceed that required to compensate the investor for risk
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T/F: When the government restricts the prices or securities that investors can exchange, then rates of return may deviate from their equilibrium level.
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T/F: any investment that when added to a portfolio, makes the overall risk of the portfolio go down, has a negative beta.
F
T/F: behavioral economists argue that they do whuch suggests markets may be efficient
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T/F: behavioral economists argue that they do whuch suggests markets may be inefficient
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T/F: behavorial finance should NOT effect prices if markets are efficient
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T/F: betas can be negative
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T/F: even though total risk (volatility) is equal to the sum of systematic risk (measured by beta) and firm-specific risk, our measure of volatility does not have to be a bigger number than our measure for beta.
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T/F: geometric mean is greater or equal to arithmetic mean
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T/F: geometric mean is less or equal to arithmetic mean
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T/F: higher correlation implies higher portfolio volatility
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T/F: holding volatility constant , individual stocks lower returns
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T/F: holding volatility constant, individual stocks have higher returns
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T/F: if two stocks have the same beta, then they must have the same expected returns, same level of expected systematic risk exposure, but not the same expected overall volatility!
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T/F: in an efficient market, the expected returns from any investment will NOT be consistent with the risk of that investment over the long term
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T/F: internal contradiction is claiming that there is possibility of beating the market in an efficient market and then requiring profit-maximizing investors to periodically seek out ways of beating the market and thus make it efficient
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T/F: it is difficult to gauge whether stock prices reflect private information
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T/F: just like a single asset (stock), portfolio has return and standard deviation
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T/F: market efficiency implies that stock prices can deviate from the true values
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T/F: market efficiency implies that stock prices cannot deviate from the true values
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T/F: portfolio beta can be estimated: regress historical portfolio returns on historical market returns
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T/F: riskiness is measured by extent to which returns deviate from returns to be
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T/F: riskiness is measured by extent to which returns deviate from what we expect returns to be (expected return)
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T/F: transactions costs of executing the necessary trades may exceed the potential profit
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T/F: two asset returns will have high covariance, if they are exposed to the same underlying factor driving them both
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T/F: when markets are efficient, the real world, that financial decisions have real implications for firm value
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T/F: when markets are not efficient, i.e. the real world, that financial decisions have real implications for firm value.
beta's security
That is, beta represents the amount by which risks that affect the overall market are amplified or dampened in a given stock or investment.
1. Cash flows 2. Discount rate
The approach to valuation requires estimates of :
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The efficient market hypothesis does not imply nor assume that all investors are smart
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The efficient market hypothesis implies that all investors are smart
-asset weight -volatilities of component assets -how component assets returns co-move
What are the 3 determinants of a portfolios volatility?
-past prices -public information -private information
What are the different types of information market efficiency refers to
1. Time preferences; risk-free rate 2. Risk Aversion; risk premium
What are the two components of discount rates?
-saves time for analyst -increases the odds significantly of finding under and over valued stocks
What do valued stocks help accomplish?
68%
What is the % of the prediction interval for normal distribution within 1 standard deviation above/below average
95%
What is the % of the prediction interval for normal distribution within 2 standard deviations above/below average
-how QUICKLY do prices change to reflect it -how ACCURATELY do prices change to reflect it
What key factors are important for when new information becomes available?
-exposure to same common risk -direction of that exposure
What two components determine correlation?
because prices do not reflect private information
Why do we have insider-trading laws?
geometric mean
a better description of historical performance of an asset
riskless arbitrage
a portfolio that has a positive cash flow today and non negative cash flows in the future
F
behavorial finance should effect prices if markets are efficient
internal contradiction
claiming that there is NO possibility of beating the market in an efficient market and then requiring profit-maximizing investors to CONSTANTLY seek out ways of beating the market and thus making it efficient.
behavioral finance
considers how certain biases may affect stock prices
portfolios
groups or baskets of assets
by using the mean of past realized returns
how do we find the estimated value?
T
illegal insider trading is not a profitable activity (strong form efficiency)
private information
information about firms that few, if any, individuals actually know STRONG FORM of market level efficiency **Stock Prices reflect ALL information (private&public) -one cannot use any type of info to predict future
public information publicly traded information (blank)
information about firms that is known (or knowable) by public SEMI STRONG form of level of market efficiency *can be used to help predict the future Stock prices reflect all (Blank)
No, because the future may differ from the past
is the expected value the best estimate?
-transaction costs -stale prices -less than perfectly competitive markets -government regulations: foreign currency
list 4 diffrent market frictions?
-weights will sum 1.0 -weights based on market values
list some characteristics of weights
beta
measure of sensitivity; sensitivity of asset's returns to market portfolio returns *known as an amplifier or de-amplifier (if less than 1) *unitless
beta for market portfolio
measures sensitivity to market Market should move one-to-one with itself! Beta therefore equal 1
idiosyncratic risk
part of a security's stand-alone risk that CAN BE ELIMINATED BY DIVERSIFICATION-driven my firm specific news
Systematic Risk
part of asset's stand alone risk that cannot be eliminated by diversification - driven by macroeconomic news aka: market risk, non-diversifiable risk, common risk
past prices
patterns observed on a stock chart WEAK Form of level of market efficiency Stock prices reflect all information in (Blank)
momentum
prior winners continue to win, prior losers continue to lose
Time preferences; risk free rate
same for all assets of similar maturity
fundamental analysis
semi strong form of evidence -use accounting data to find mispriced securities -fundamental information seems to be impounded into prices quickly, leaving little opportunity for profit **Evidence that market response is incomplete
diversification
spreading risk across multiple assets so gains in some assets may offset losses in others
Volatility
standard deviation of stock's return is often referred to as
disposition effect
tendency to keep losers and sell winners aka hold stocks that have lost value and sell stocks that have risen value
standard deviation
the square root of the variance
variance
the sum of squared deviations from mean (scaled by N-1)
stand alone risk
the total risk of an asset measured by standard deviation
loss aversion
type of behavioral bias which refers to people's tendency to strongly prefer avoiding losses to acquiring gains
arithmetic mean
used to estimate asset's future expected return using PAST performance
risk aversion; risk premium
variation in discount rates between assets here; riskier assets = higher risk premium
technical analysis
weak form of evidence that: -attempts to identify predictable patterns in prices and trade on it -little evidence, it works after trading costs -strong evidence for momentum
return on portf
weighted sum of returns on its components
Variance and Standard Deviation
what are measures of stock's risk that help understand a stock's return?
-no one likes risk ***we require compensation for taking risks in form higher expected return -suggests discount rate be positive
what are some characteristics of risk aversions when it comes to intuition on discount rates?
-we prefer $$ today to $$ in future -rather consume (invest) now than later -suggests discount rate be POSITIVE
what are some characteristics of time preferences when it comes to intuition on discount rates?
-difficult to search for new information (expensive and time consuming) -only beneficial if value exceeds its costs -trading securities is costly -capital is scarce (large amounts of capital may be required to eliminate mispricing) -
what are some factors involved in moving toward efficiency (barriers/limits)?
The expected return on that investment will be less than the risk-free rate
what are the consequences of a negative beta?
1. time preferences 2. risk aversion
what are the two intuitions on discount rates?
there is an equal chance that stocks are under or over valued at any point in time
what does randomness imply for market efficiency?
E(R)
what is the symbol referred for the expected value?
market frictions
what makes a market inefficient?
-facilitates capital budgeting -helps one rely on market prices to guide investments -understanding alternative views
why should one care about market efficiency?