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financial econ test 2
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Gravity
Terms in this set (50)
Holding period return (HPR)
rate of return over a given investment period; no distinction for length of period
Arithmetic average
sum of each period's return divided by the number of periods
Annual percentage rate (APR)
per period rate times number of periods in a year
Effective Annual rate (EAR)
Works to compound interest
Scenario analysis
process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realized in each case; List possible outcomes and specify the likelihood of each one
Probability distribution
captures all possible outcomes and the probability associated with each possible outcome
Expected return
Mean return; the return we expect the security to generate over time; the mean value of the distribution of HPR
Variance
expected value of squared deviation from the mean (capture the range and the potential volatility)
Standard deviation
square root of variance
Normal distribution
About two-thirds of all outcomes will be within 1 standard devision and about 95% within two standard deviations.
Value-at-risk (VAR)
measure of downside risk; the worst loss that will be suffered with a given probability, often 5%; Use this to capture exposure to a 'tail event'
Risk-free rate
rate of return earned with certainty (Treasury bond rate)
Risk premium
expected return in excess of that on risk-free securities; expected return in excess of risk-free rate
Risk aversion
reluctance to accept risk. Measure through revealed preference (derived measure)
Sharpe Ratio
ratio of portfolio risk premium to standard deviation; Measures the reward for volatility on the portfolio level. Indicates the expected risk premium per unit of volatility on a portfolio.
Fisher Effect
the nominal return (interest rate) should change one for one with a change in inflation. Inflation should have no effect on real return.
Asset allocation
portfolio choices across broad asset classes
Capital allocation
choice between risky and risk-free assets
Risk-free assets
Treasury securities, CDs, money market funds, commercial paper
Capital allocation line (CAL)
plot of all risk-return combinations for all possible allocations between the risky and risk-free asset. (all possible risk-return combinations in our portfolio)
Passive strategy
investment policy that avoids security analysis. Focus on index funds, preferably low cost.
Capital Market Line
the capital allocation line using a market-index portfolio as the risky asset
market risk
risk factors common to the whole economy; systematic risk, nondiversifiable risk, etc.
Covariance
how much two variables change together (linear dependence)
Correlation Coefficient
shows how the returns across two assets vary
Investment Opportunity Set
set of all available risk-return combinations
Separation property
the property that implies portfolio choice can be separated into two independent tasks:
1. Determine the optimal risky portfolio allocation (purely technical problem)
2. Determine the optimal mix between risky assets and the risk-free portfolio (this is the personal choice and is based on each individual's level of risk aversion and/or their personal situation)
Index market
relates stock returns to returns on both a broad market index and firm-specific factors
capital asset pricing model (CAPM)
a model that relates required rate of return on a security to its systematic risk (as measured by β)
Market-wide
market is perfectly competitive and all investors have an opportunity for equal profit and unlimited lending/borrowing at the risk-free rate.
investor specific
rational (so mean/variance optimizer; maximizing Sharpe ratio) with homogeneous expectations. The only difference across investors is initial wealth and risk aversion.
Security Market Line (SML)
Represents expected return-beta relationship. Focuses on individual asset premium versus individual asset risk.
**shows return required to compensate investors for beta or market sensitivity risk.
Fama-French Three-Factor Model
Started with market index portfolio and added measures for firm size and book-to-market value to explain/forecast returns
Arbitrage
creation of rissoles profits made possible by relative misplacing among securities; identifying relative mispricing among securities and using that information to generate profits.
Arbitrage pricing theory (APT)
a theory of risk-return relationships derived from no-abritrage considerations in large capital markets; equilibrium rates of return that will prevail in markets over time.
Random walk
the idea that stock prices change randomly and unpredictably.
Efficient markets hypothesis
the hypothesis that prices of securities fully reflect available information about securities
Weak form EMH
the assertion that stock prices already reflect all information contained in the history of past trading
Semistrong-form EMH
the assertion that stock prices already reflect all publicly available information; (so contains both past and current information).
Strong-form EMH
the assertion that stock prices immediately reflect all available information, including inside information (public and nonpublic information).
Technical analysis (chartists)
research on recurrent and predictable stock/security price patterns and on measures of buy and sell patterns.
Fundamental analysis
research on determinants of a stock's value,such as earnings and dividend prospects, expectations for future interest rates and risk of the firm; calculate the discount present value of the stock and buy if the discount PV exceeds the stock price.
Passive investment strategy
buying a well-diversified portfolio without trying to identify mispriced securities. **invest in index funds (mutual funds that attempt to replicate the performance of a market index)
Magnitude issue
difference is so incremental that it is tough to measure accurately, especially given the year-to-year market volatility.
Selection bias
any published strategy will be ineffective.
Lucky event bias
superior record of some stock pickers could be luck.
Small firm effect
stocks of small firms tend to earn abnormally large returns, primarily in the month of January
Market anomalies
patterns of returns that appear to contradict EMH:
Book-to-market effect
the tendency for investments in shares of firms with high ratios of book value to market value to generate abnormal returns; Tendency for firms with high book-to-market value to generate abnormally large returns.
bubbles
Longer term deviations from equilibrium price (housing crisis, tulips in Holland, etc.). Market price does not reflect market conditions.
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