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Finance exam 3
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Terms in this set (47)
Common stock
represents ownership in corporation
Stock markets
provide liquidity through stock exchanges
provide means for buyers and sellers to transact
EX: new york stock exchange (NYSE), American Stock exchange (AMEX), NASDAQ, FTSE, Nikkei
Quoted Bid
highest price at which market makers will buy
Quoted ask
lowest price at which market makers will sell
Trading stocks
market order is filled at current ask price, limit order only executed if ask price is below price target
Basic stock valuation
present value calculations used (stock cash flows are unknown)
Find present value of future dividends and future selling price
Todays value= present value of next years dividend and price
Dividend discount model
stocks value is present value of an infinite stream of dividends and no future final sales price
constant growth model
assumes growth rate smaller than discount rate
next years dividend/ (discount rate- growth rate)
preferred stock
has priority over common stock in bankruptcy
pays a constant dividend
valued using constant-growth model
expected return
investors demand higher returns from higher-risk investments
dividend yield and expected stock price appreciation comprise expected return
is a forward looking calculation that includes risk measures
variable growth rate valuation
combines present value cash flow with constant growth rate model
variable growth rate stock
stock value= present value of each dividend during first growth stage + present value of second growth stage
Dollar return
includes capital gain or loss as well as income
percentage returns
returns across different investments are more easily compared because they are standardized
can be used for most types of investments
performance of asset classes
historically stocks have outperformed bonds and cash on an average return basis
average returns not accurate picture of annual returns
computing volatility
standard deviation (StD) measures volatility
StD is the square root of the variance
represents the total risk of a security portfolio
standard deviation
the larger the standard deviation, the higher the risk
Risk of asset classes
stocks are more volatile than bonds or t-bills
risk vs. return
with any investment there is a risk/return tradeoff
the coefficient of variation (coV) is a relative measure of this relationship
coefficient of variation
amount of risk (measured by volatility) per unit of return
forming portfolios
diversifying to reduce risk
modern portfolio theory: diversification, portfolio return
diversifying to reduce risk
two main components of total risk: firm- specific risk, market risk
Total risk= firm specific risk + market risk
firm specific risk
referred to as diversifiable risk
market risk
non diversifiable risk
this risk applies across all securities in any given market
modern portfolio theory
adding stocks to a portfolio reduces risk
risk is reduced when securities are combined
optimal portfolio
combination of securities that produce the highest return for the amount of risk taken
diversification
when stocks returns are not perfectly correlated--- price movements often counteract each other
with perfect positive correlation diversification does not affect risk
return calculation
comprised of the individual returns of each security in portfolio and the relative weight of each in the portfolio
risk premiums
required return, risk premium, market risk
required return
return that investors demand for the level of risk taken
risk premium
reward investors require for taking risk
market risk premium
is the reward for taking unsystematic stock market risk
capital asset pricing model (CAPM)
best known capital asset pricing model
starts with modern portfolio theory
efficient frontier
demonstrates the highest expected return for each level of risk
adding a risk free asset improves return for each level of risk
beta
measures the sensitivity of a stock or portfolio to market risk
beta greater than 1= more risky than market (higher risk premium)
beta less than 1= less risky (lower risk premium)
security market line
shows relationship between risk and return for any stock or portfolio
similar to capital market line (risk is characterized by beta, not standard deviation)
portfolio beta
weighted average of portfolio stocks betas
finding beta
two ways:
can compute with data from companies and market portfolio returns
find in published data from financial outlets
capital market efficiency
efficient markets feature:
many buyers and sellers, no high barriers to entry, free and available information, low trading or transaction costs
efficient market hypothesis
states that security prices fully reflect all available information
3 levels:
weak form, semi strong form, strong form
weak form efficiency
current prices reflect all information derived from trading
includes current and past stock prices and trading volume
semistrong form efficiency
current prices reflect all available public information
includes information like financial statements, news, analysts opinions
strong form efficiency
current prices reflect all information
public
privately held information
behavioral finance
people behave in irrational ways
both optimism and pessimism can be extreme
overconfidence is tendency to overestimate knowledge and underestimate risk
implications for financial managers
managers must understand the risk/return relationship and implications
and address stockholders concerns and requirements
what kind of stock doesn't come with voting rights
preferred stock
what kind of stock is a the bottom of the todempole
common stock
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