BEC 2011 Chapter 5

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Rate of Return

a. A return is the amount received by an investor as compensation for taking on the risk of the investment.
Return on investment = Amount received - Amount invested
An investor paid $100,000 for an investment that returned $112,000. The investor's return is $12,000 ($112,000 —$100,000).

Two Basic Types of Investment Risk
a. Systemcatic risk
b. Unsystematic risk

b. Systematic risk, also called market risk, is the risk faced by all firms. Changes in the economy as a whole, such as the business cycle, affect all players in the market.
1) For this reason, systematic risk is sometimes referred to as undiversifiable risk. Since all investment securities are affected, this risk cannot be offset through portfolio diversification.
c. Unsystematic risk, also called company risk, is the risk inherent in a particular investment security. This type of risk is determined by the issuer's industry, products, customer loyalty, degree of leverage, management competence, etc.

a. Credit risk
b. Foreign exchange risk
c. Interest rate risk

a. Credit risk is the risk that the issuer of a debt security will default. This risk can be gauged by the use of credit-rating agencies.
b. Foreign exchange risk (or exchange rate risk) is the risk that a foreign currency transaction will be affected by fluctuations in exchange rates.
c. Interest rate risk is the risk that an investment security will fluctuate in value due to changes in interest rates. In general, the longer the time until maturity, the greater the degree of interest rate risk.

d. Industry risk
e. Political risk
f. Liquidity risk

d. Industry risk is the risk that a change will affect securities issued by firms in a particular industry. For example, a spike in fuel prices will negatively affect the airline industry.
e. Political risk is the probability of loss from actions of governments, such as from changes in tax laws or environmental regulations or from expropriation of assets.
f. Liquidity risk

g. Business risk (or operations risk)

g. Business risk (or operations risk) is the risk of fluctuations in earnings before interest and taxes or in operating income when the firm uses no debt. It is the risk inherent in its operations that excludes financial risk, which is the risk to the shareholders from the use of financial leverage. Business risk depends on factors such as demand variability, sales price variability, input price variability, and amount of operating leverage.

risk averse

They have a diminishing marginal utility for wealth. In other words, the utility of additional increments of wealth decreases. The utility of a gain does not outweigh the disutility of a potential loss of the same amount.

risk-neutral

risk-neutral investor adopts an expected value approach because (s)he regards the utility of a gain as equal to the disutility of a loss of the same amount. Thus, a risk-neutral investor has a purely rational attitude toward risk.

A risk-seeking

A risk-seeking investor has an optimistic attitude toward risk. (S)he regards the utility of a gain as exceeding the disutility of a loss of the same amount.

8 types of investments in most to least risky

Common stock
Convertible preferred stock
Preferred stock
Income bonds
Subordinated debentures
Second mortgage bonds
First mortgage bonds
Us treasury bonds

here are two types of probability -- objective and subjective. They differ in how they are calculated.

a. Objective probabilities are calculated from either logic or actual experience. For example, when rolling a six-sided die, logic indicates that the probability for each outcome (a given face turned upward) is about .167
b. Subjective probabilities are estimates, based on personal judgment, of the likelihood of future events. In finance, subjective probability can indicate the degree of confidence a person has that a certain outcome will occur, e.g., the future performance of a stock.

probability distribution

A probability distribution is the set of all possible outcomes of a decision, with a probability assigned to each outcome. For example, a simple probability distribution might be defined for the possible returns on a stock investment. Such a probability distribution is discrete because the outcomes are limited.

continuous distribution
normal distribution

1. A continuous distribution is one for which the outcomes are theoretically infinite. The normal distribution is the best-known continuous distribution. The normal distribution has a symmetrical, bell-shaped curve centered about the mean.
Distance in Standard Deviations Area under the Curve
1.0 68%
2.0 95.5%
3.0 99.7%

The standard deviation gives an exact value for the tightness of the distribution and the riskiness of the investment.

a) A large standard deviation reflects a broadly dispersed probability distribution, meaning the range of possible returns is wide. Conversely, the smaller the standard deviation, the tighter the probability distribution and the lower the risk.

The correlation coefficient has a range from 1.0 to —1.0.

a) Perfect positive correlation (1.0) means that the two variables always move together.
b) Perfect negative correlation (-1.0) means that the two variables always move in the opposite direction.
c) If a pair of securities has a correlation coefficient of 1.0, the risk of the two together is the same as the risk of each security by itself. If a pair of securities has a correlation coefficient of —1.0, all specific (unsystematic) risk has been eliminated.

1) Asset allocation

1) Asset allocation is a key concept in financial planning and money management. It is the process of dividing investments among different kinds of assets, such as stocks, bonds, real estate, and cash, to optimize the risk-reward tradeoff based on specific situations and goals.

feasible portfolio

2) An investor wants to maximize return and minimize risk when choosing a portfolio of investments. A feasible portfolio that offers the highest expected return for a given risk or the least risk for a given expected return is an efficient portfolio.

. Two important decisions are involved in managing a company's portfolio

1) The amount of money to invest
2) The securities in which to invest

capital asset pricing model (CAPM)

risk-free rate

Market Risk premium

a. The capital asset pricing model (CAPM) quantifies the expected return on an equity security by relating the security's level of risk to the average return available in the market.
b. The CAPM formula is the sum of two components, the risk-free rate of return and the expected premium provided by the stock.
1) The risk-free rate (denoted RE) is the return currently provided by the safest investments, i.e., government securities.
2) The market risk premium (denoted RM — RE) is the excess of the average return on the market over the risk-free rate.

3) Arbitrage pricing theory (APT)

3) Arbitrage pricing theory (APT) arose from dissatisfaction with the CAPM's reliance on a single systematic risk factor to explain an asset's return. APT instead uses multiple systematic risk factors, each weighted by a separate beta value.
4) 1) Examples of the many potential systematic risk factors are the gross domestic product (GDP), inflation, and real interest rates.

derivative instrument

a. A derivative instrument is an investment transaction in which the parties' gain or loss is derived from some other economic event, for example, the price of a given stock, a foreign currency exchange rate, or the price of a certain commodity

Hedging
Long Position

Short position

a. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements.
b. An entity has a long position in an asset whenever the entity owns the asset. An entity with a long position therefore benefits from a rise in the asset's value.
c. An entity has a short position in an asset when the entity sells an asset that it does not own at the time of the sale. Entities take short positions when they believe the value of the asset will decrease.

Options
Call options

a. A party who buys an option has bought the right to demand that the counterparty (the seller or "writer" of the option) buy or sell an underlying asset on or before a specified future date. The buyer holds all of the rights and the seller has all of the obligations. The buyer pays a fee to be able to dictate — in the future —
b. A call option gives the buyer (holder) the right to purchase (i.e., the right to "call" for) the underlying asset (stock, currency, commodity, etc.) at a fixed price.

Put option
Underlying
Holder
Writer

c. A put option gives the buyer (holder) the right to sell (i.e., the right to "put" onto the market) the underlying asset (stock, currency, commodity, etc.) at a fixed price.
d. The asset that is subject to being bought or sold under the terms of the option is referred to as the underlying.
e. The party buying an option is referred to as the holder. The seller is referred to as the writer.
f. The exercise of an option is always at the discretion of the option holder (the buyer) who has, in effect, bought the right to exercise the option or not. The seller of an option has no choice; (s)he must perform if the holder chooses to exercise.

European option
American option.

1) An option that can be exercised only on its expiration date is referred to as a European option.
2) An option that grants the buyer the right to exercise anytime on or before expiration is an American option.

exercise price (or strike price)

option price

1) The exercise price (or strike price) is the price at which the owner can purchase (in the case of a call) or sell (in the case of a put) the asset underlying the option contract.
2) The option price, also called option premium, is the amount the buyer pays to the seller to acquire an option.

covered

A covered option is one in which the seller (writer) is hedging an already existing position. This existing position could be a long or short position.
a) A party selling a covered option is not speculating but rather is writing the option as a vehicle to insure his/her existing position.

Valuing an Option consists of two components

The price of an option (the option premium) consists of two components, intrinsic value and the time premium, also called extrinsic value (option premium = intrinsic value + time premium).

-intrinsic value of a call
option
-intrinsic value of a put option

The intrinsic value of a call option is the amount by which the exercise price is less than the current price of the underlying.

The intrinsic value of a put option is the amount by which the exercise price is greater than the current price of the underlying.
a) If an option has a positive intrinsic value, it is said to be in-the-money.

time premium

3) The time premium (extrinsic value) of an option is the extra amount investors are willing to pay for the added protection provided by an option over a straightforward long or short position in the underlying

trading at parity

an option has no time premium, its price consists entirely of its intrinsic value. Such an option is said to be trading at parity. If an option is out¬of-the-money, its price consists entirely of its time premium.

Exercise price

a) In general, the buyer of a call option benefits from a low exercise price. Likewise, the buyer of a put option generally benefits from a high exercise price.
b) Thus, an increase in the exercise price of an option results in a decrease in the value of a call option and an increase in the value of a put option.

Price of underlying

a) As the price of the underlying increases, the value of a call option also will increase; the exercise price is more and more of a bargain with each additional dollar in the price of the underlying.
b) By the same token, the value of a put option will decrease as the price of the underlying increases since there is no advantage in selling at a lower¬than-market price.

Interest rates

c) Buying a call option is like buying the underlying on credit. The purchase of the option is a form of down payment. If the option is exercised in a period of rising interest rates, the exercise price is paid in inflated dollars, making it more attractive for the option holder.
a) A rise in interest rates will therefore result in a rise in the value of a call option and a fall in the value of a put option.

Time until expiration

The more time that exists between the writing of an option and its expiration, the riskier any investment is. Thus, an increase in the term of an option (both calls and puts) will result in an increase in the value (i.e., price) of the option.

Volatility of price of underlying

a) The more volatile the price of the underlying, the more likely it is to pass through the strike price, making the option a worthwhile investment.
b) An increase in the volatility of the price of the underlying will result in an increase in the value of the option (both calls and puts).

Swaps
three types
1. interest rate swaps
2. Currency swaps
3. credit default swaps

1) Interest rate swaps are agreements to exchange interest payments based on one interest structure for payments based on another structure.
2) Currency swaps are agreements to exchange cash flows denominated in one currency for cash flows denominated in another.
3) Credit default swaps are agreements whereby one of the parties indemnifies the other against default by a third party.

8. Duration hedging

Duration hedging involves hedging interest-rate risk. Duration is the weighted average of the periods of time to interest and principal payments. If duration increases, the volatility of the price of the debt instrument increases.

One type of risk to which investment securities are subject can be offset through portfolio diversification. What type of risk is this?

One type of risk to which investment securities are subject can be offset through portfolio diversification. What type of risk is this?

Investor holds two stocks, one has a standards deviation of returns of 4.2 and the other has a standards deviation of return of 6.3. the coefficient of correlation between the two stock sis .75 if the investors portfolio contains only these two stocks what is the portfolios covariance?

.75 X4.2X6.3=19.845

If a company enters into an agreement to slowly purchase a competitor by receiving a portion of stock. The company is worried about the decreasing value of the competitors stock price, how can the company lower the risk of this?

Purchasing a put option on the stock, a put option is the right to sell stock at a given price within a certain period .

A distinguishing feature of a futures contract is that it's,

The price is marked to market each day.

What is the goal of hedging interest rate risk by matching the duration of assets with the duration of liabilities?

The firm is immunized against interest rate risk when the total price change for assets equals the total price change for liabilities.

Beta coefficient

a measure that describes the risk of an investment projects relative to other investments in general.

What measures the volatility of returns together with their correlation with the return of other securities.

Covariance

What is the rate of return of this investment
Cost of investment Amount Received
8,500 8,390
4,200 4610

a. -1.3%
b. 9.8%

Remember to put in percentages!!!!!!!

The risk to which all investment securities are subject is known as

Systematic risk

One type of risk to which investment securities are subject can be offset through portfolio
diversification. This type of risk is referred to as

Company risk.
Unsystematic risk, also called company or diversifiable risk, is the risk
inherent in a particular investment security. Since individual securities are affected differently
by economic conditions, this risk can be offset through portfolio diversification.

Which of the following factors is inherent in a firm's operations if it utilizes only equity
financing?
A. Financial risk.
B. Business risk.
C. Interest rate risk.
D. Marginal risk.

Business risk is inherent in the operation of all firms. It depends on
general economic factors such as demand variability, sales price variability, and input price
variability. It specifically excludes the effects of the financial risk encountered when using
financial leverage.

Political risk may be reduced by
Entering into a joint venture with another A. foreign company.
Making foreign operations dependent on the domestic parent for technology, markets, and
supplies.
B.
C. Refusing to pay higher wages and higher taxes.
D. Financing with capital from a foreign country.

Political risk is the risk that a foreign government may act in a way that
will reduce the value of the company's investment. Political risk may be reduced by making
foreign operations dependent on the domestic parent for technology, markets, and supplies

A company holds industrial development bonds issued by a county in another state. The county commission has announced that its financial condition has changed drastically and that it is considering defaulting on the next interest and principal payment on these bonds. This situation
exposes the company to all of the following types of risk except
A. Liquidity risk.
B. Interest rate risk.
C. Credit risk.
D. Political risk

Interest rate risk is the risk that an investment security will fluctuate in value due to changes in interest rates. The potential default is based on the issuer's financial
condition, not the movement of interest rates in the market.

Catherine & Co. has extra cash at the end of the year and is analyzing the best way to invest the
funds. The company should invest in a project only if the
A.Expected return on the project exceeds the return on investments of comparable risk.
B. Return on investments of comparable risk exceeds the expected return on the project.
C. Expected return on the project is equal to the return on investments of comparable risk.
D. Return on investments of comparable risk equals the expected return on the project

A. Investment risk is analyzed in terms of the probability that the actual
return on an investment will be lower than the expected return. Comparing a project's expected
return with the return on an asset of similar risk helps determine whether the project is worth
investing in. If the expected return on a project exceeds the return on an asset of comparable
risk, the project should be pursued.

Rank in order of highest risk/return possibility
1. Preferred stock
2. common stock
3. income bond
4. mortgage bonds
5. us treasury bonds
6. Debentures

1. common stock
2. preferred stock
3. income bonds
4. debentures- unsecured bond
5. mortgage bonds
6. us treasury

To assist in an investment decision, Gift Co. selected the most likely sales volume from several
possible outcomes. Which of the following attributes would that selected sales volume reflect?
A. The midpoint of the range.
B. The median.
C. The greatest probability.
D. The expected value.

Probability is important to management decision making because of the
uncertainty of future events. Probability estimation techniques assist in making the best
decisions in the face of uncertainty. Consequently, the most likely sales volume is the one with
the greatest probability.

Probability (risk) analysis is
Used only for situations involving five or fewer A. possible outcomes.
B. Used only for situations in which the summation of probability weights is less than one.
C. An extension of sensitivity analysis.
D. Incompatible with sensitivity analysis.
[21] Gleim #: 5.2.21 -- Source: Publisher, adapted

Answer (C) is correct. Probability (risk) analysis is used to examine the array of possible
outcomes given alternative parameters. Sensitivity analysis answers what-if questions when
alternative parameters are changed. Thus, risk (probability) analysis is similar to sensitivity
analysis: both evaluate the probabilities and effects of differing inputs or outputs

Find the level of risk
Expected return=16%
Standard Deviation=10%

=10%/16%

If the total weighted squared variance of techspace stock is 301, the standard deviation is=

sqroot of 301= 17.35

How do you Find the Coefficient of Variation?

Standard Deviation/ Expected Rate of Return

The returns on two stocks can be correlated in values except those that are
A. Positive.
B. Negative.
C. Neutral.
D. Skewed.

The correlation coefficient (r) measures the degree to which any two
variables are related. It ranges from -1.0 to 1.0. Perfect positive correlation (1.0) means that
the two variables always move together. Perfect negative correlation (-1.0) means that the two
variables always move inversely to one another. A neutral correlation, or no correlation, is 0.0.
Skewed is a nonsense concept in this context.
[38] Gleim #: 5.2.38 -- Source: Publisher, adapted

In theory, which of the following coefficients of correlation would eliminate risk in an
investment portfolio?
A. 1.0
B. 0.0
C. -1.0
D. No theoretical coefficient exists for the elimination of risk in a portfolio context.

Answer (C) is correct. The correlation coefficient measures the degree to which any two
variables, e.g., two stocks in a portfolio, are related. Perfect negative correlation (-1.0) means
that the two variables always move in the opposite direction. Given perfect negative
correlation, risk would in theory be eliminated. In practice, the existence of market risk makes
perfect correlation all but impossible.

Listed below are four numbers. Which of these numbers represents the coefficient of
correlation of a stock portfolio with the least risk?
A. 100.0
B. 1.0
C. 0.0
D. -1.0

Answer (D) is correct. The correlation coefficient measures the degree to which any two
variables, e.g., two stocks in a portfolio, are related. Perfect negative correlation (-1.0) means
that the two variables always move in the opposite direction. Given perfect negative
correlation, risk would in theory be eliminated. In practice, the existence of market risk makes
perfect correlation all but impossible.

Which of the following specifically measures the volatility of returns together with their
correlation with the returns of other securities?
A. Variance.
B. Standard deviation.
C. Coefficient of variation.
D. Covariance.

Answer (D) is correct. An important measurement used in portfolio analysis is the covariance. It measures
the volatility of returns together with their correlation with the returns of other securities. For two stocks X
and Y, the covariance is
Coefficient of correlation X standard deviation(x) X standard deviation (Y)

The systematic risk of an individual security is measured by the
A. Standard deviation of the security's rate of return.
B. Covariance between the security's returns and the general market.
C. Security's contribution to the portfolio risk.
D. Standard deviation of the security's returns and other similar securities

Answer (B) is correct. The covariance is a measure of the mutual volatility of two securities.
The covariance between the return of a single security and the return on the market as a whole
is therefore the systematic (or market) risk of the single security.

A feasible portfolio that offers the highest expected return for a given risk or the least risk for a
given expected return is a(n)
A. Optimal portfolio.
B. Desirable portfolio.
C. Efficient portfolio.
D. Effective portfolio.

Answer (C) is correct. A feasible portfolio that offers the highest expected return for a given
risk or the least risk for a given expected return is called an efficient portfolio.

What is the formula for the beta coefficient of a security?

Covariance of the returns on the market and on the security ÷ Variance of the return on
the market.
The word beta is derived from the regression equation for regressing
the return of an individual security (the dependent variable) to the overall market return. The
beta coefficient is the slope of the regression line. The beta for a security may also be
calculated by dividing the covariance of the return on the market and the return on the security
by the variance of the return on the market.

The incremental benefits of portfolio diversification initially decrease as the number of
different securities held increases. The benefits become extremely small when more than about
__________ different securities are held.

In principle, diversifiable risk should continue to decrease as the
number of different securities held increases. In practice, however, the benefits of
diversificiation become extremely small when more than about 20 to 30 different securities are
held.

What is the major difference between the capital asset pricing model (CAPM)
and arbitrage pricing theory (APT)?

CAPM uses a single systematic risk factor to explain an asset's return
whereas APT uses multiple systematic factors

Duration hedging involves hedging interest-rate risk by matching the duration of assets with the
duration of liabilities. Which of the following is a true statement about duration hedging?

The goal of duration hedging is not to equate the duration of assets and
the duration of liabilities but for the following relationship to apply:
The firm is immunized against interest-rate risk when the total price change for assets equals
the total price change for liabilities

An automobile company that uses the futures market to set the price of steel to protect a profit
against price increases is an example of

B. A long hedge.A change in prices can be minimized or avoided by hedging. Hedging is
the process of using offsetting commitments to minimize or avoid the impact of adverse price
movements. The automobile company desires to stabilize the price of steel so that its cost to
the company will not rise and cut into profits. Accordingly, the automobile company uses the
futures market to create a long hedge, which is a futures contract that is purchased to protect
against price increases.

The type of option that does not have the backing of stock is called a(n)

C. Naked option.

Which one of the following is not a determinant in valuing a call option?

C. Forward contract price.
The exercise price, the expiration date, and the interest rate are all
determinants in valuing a call option.

A company has recently purchased some stock of a competitor as part of a long-term plan to
acquire the competitor. However, it is somewhat concerned that the market price of this stock
could decrease over the short run. The company could hedge against the possible decline in the
stock's market price by

B. Purchasing a put option on that stock
A put option is the right to sell stock at a given price within a certain
period. If the market price falls, the put option may allow the sale of stock at a price above
market, and the profit of the option holder will be the difference between the price stated in the
put option and the market price, minus the cost of the option, commissions, and taxes. The
company that issues the stock has nothing to do with put (and call) options.

A straight bond with a similar rate is priced at $1,000. If the value of the issuer's call option is
estimated to be $50, what is the value of the callable bond?

A callable bond is not as valuable to an investor as a straight bond.
Thus, the $50 call option is subtracted from the $1,000 value of a straight bond to arrive at a
$950 value for the callable bond.

Garcia Corporation has entered into a binding agreement with Hernandez Company to purchase
400,000 pounds of Colombian coffee at $2.53 per pound for delivery in 90 days. This contract
is accounted for as a
A. Financial instrument.
B. Firm commitment.
C. Forecasted transaction.
D. Fair value hedge

Answer (B) is correct. A firm commitment is an agreement with an unrelated party, binding on
both parties and usually legally enforceable, that specifies all significant terms and includes a
disincentive for nonperformance

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