FI 381: Final Exam- Chapters 1, 2, 3, 7, 8, 9, 13 (Dr. D'Souza)
Terms in this set (251)
commitment of current resources in the expectation of deriving greater resources in the future
Assets used to produce goods and services
Land, buildings, equipment, and knowledge that can be used to produce goods and services
claims on real assets or the income generated by them
Stocks and bonds
Fixed income (debt) securities
Pay a specified cash flow over a specific period.
Promise either a fixed stream of income or a stream of income that is determined according to a specified formula
For example, a corporate bond typically would promise that the bondholder receive a fixed amount of interest each year
an ownership share in a corporation
They receive any dividends that the firm may pay and have prorated ownership in the real assets of the firm.
If the firm is successful, the value of equity will increase; if not, it will decrease.
securities providing payoffs that depend on the values of other assets
options and futures contracts
For example, a call option on a share of Intel stock might turn out to be worthless if Intel's share price remains below a threshold or "exercise: price such as $35 a share, but it can be quite valuable if the stock price rises above that level.
Are so named because their values derive from the prices of other assets.
Conflicts of interest between managers and stock holders
Potential conflicts of interest because managers, who are hired as agents of shareholders, may pursue their own interests instead
allocation of an investment portfolio across broad asset classes.
Choice of specific securities within each asset class
Analysis of the value of securities
Involves the valuation of particular securities that might be included in the portfolio.
For example, an investor might ask whether Merck or Pfizer is more attractively price. Both bonds and stocks must be evaluated for investment attractiveness, but valuation is far more difficult for stocks because a stock's performance is usually far more sensitive to the condition of the issuing firm
Assets with higher expected returns entails greater risk
Higher-risk assets priced to offer higher expected returns than lower risk assets.
Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There will almost always be risk associated with investments.
Buying and hiding a diversified portfolio without attempting to identify mispriced securities.
Calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis.
Attempting to identify mispriced securities or to forecast broad market trends.
For example, increasing one's commitment to stocks when one is bullish on the stock market. If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.
Institutions that "connect" borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.
have evolved to bring together the suppliers of capital (investors) with the demanders of capital (primarily corporations and the federal government). These financial intermediaries include banks, investment companies, insurance companies, and credit unions.
They have their own securities to raise funds to purchase the securities of other corporations
Firms managing funds for investors. An investment company may manage several mutual funds.
Pool and manage the money of many investors, also arise out of economies of scale.
The problem is that most household portfolios are not large enough to be spread among a wide variety of securities. It is very expensive in terms of brokerage fees and research costs to purchase one or two shares of many different firms.
Firms specializing in the sale of new securities to the public, typically by underwriting the issue.
Specialize in such activities that can offer their services at a cost below that or maintaining an in-house security issuance division.
Advise an issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth.
A market in which new issues of securities are offered to the public
Previously issued securities are traded among investors.
Venture Capital (VC)
Money invested to finance a new firm
Sources are dedicated venture capital finds, wealthy individuals known as angel investors, and institutions such as pension funds
Investments in companies that are not traded on a stock exchange.
pooling loans into standardized securities backed by those loans, which can then be traded like any other security
risk of breakdown in the financial system, particularly due to spillover effects from one market into others.
When lenders such as banks have limited capital, and are afraid of further losses, they may rationally choose to hoard their capital instead of lending it out to customers such as small firms, thereby exacerbating funding problems for their customary borrowers.
Nature of Investment
reduce current consumption for greater future consumption
Major classes of Financial Assets or Securities
fixed-income (debt) securities, Common stock (equity), Derivative securities
Fixed- Income Securities examples
Money market instruments (bank certificates of deposit, T-bills, commercial paper, etc.), bonds, preferred stock
ownership stake in entity, residual cash flow
contract, value derived from underlying market condition
Allocation of scare resources against competing and unlimited ends
Residual Cash Flow
You can only get paid with what is left over
Informational Role of Financial Markets
Do market prices equal the fair value estimate of a security's expected future risky cash flows?
Can we rely on markets to allocate capital to the best uses?
Consumption smoothes over time
When current basic needs are met, shift consumption through time by investing surplus
Investors can choose desired risk level
-Bond vs. stock of company
-Bank CD vs. Company bond
-Risk and return trade-off
Separation of Ownership and Management
Large size of firms requires separate principals and agents
Performance based compensation
Board of directors may fire managers
Threat of takeovers
Corporate Governance and Corporate Ethics
Businesses and markets require trust to operate efficiently
-without trust additional laws and regulations are required
-laws and regulations are costly
Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest
Misleading Research Reports
Citicorp, Merrill Lynch, others
Auditors: Watchdogs or Consultants?
Arthur Andersen and Enron
Requires more independent directors on company boards
Requires CFO to personally verify the financial statements
Created new oversight board for the accounting/ audit industry
Charged board with maintaining a culture of high ethical standards.
include short-term, highly liquid, and relatively low-risk debt instruments
is a subsection of the debt market
many of these securities trade in large denominations and so are out of the reach of the individual investors
short-term government securities issued at a discount from face value and returning the face amount at maturity.
are the most marketable of all money market instruments
Represent the simplest form of borrowing.
can be purchased directly from the treasury or on the secondary market from a government securities dealer.
They are highly liquid- easily converted to cash and sold at low transaction cost with little price risk.
Issuer: Federal Government
Denomination: $100, commonly $10,000
Maturity: 4, 13, 26, or 52 weeks
Default Risk: None
Interest type: Discount
Taxation: Federal owed; exempt from state and local
Certificate of Deposit (CD)
is a time deposit with a bank.
May not be withdrawn on demand.
The bank pays interest and principal to the depositor only at the end of the fixed term of the CD.
Issuer: Depository instituions
Denomination: Any, $100,000 or more marketable
Maturity: Varies, typically 14-day minimum
Liquidity: CDs of 3 months or less are liquid if marketable
Default Risk: First $100,000 ($250,000) insured
Interest type: Add on
Taxation: Interest income fully taxable
Short-term unsecured debt issued by large corporations.
Considered to be a fairly safe asset, given that a firm's condition presumably can be monitored and predicted over a term as short as one month.
Traded in secondary markets, and so is quite liquid.
Issuer: Large Creditworthy corporations, financial institutions
Denomination: Minimum $100,000
Maturity: Maximum 270 days, usually 1-2 months
Liquidity: CP of 3 months or less is liquid if marketable
Default Risk: Unsecured, rated, mostly high quality
Interest type: Discount
Taxation: Interest income fully taxable
New Innovation: Asset-backed commercial paper
An order to a bank by a customer to pay a sum of money at a future date.
Originate when a purchaser authorizes a bank to pay a seller for goods at later date (time draft)
When purchaser's bank "accepts" draft, it becomes contingent liability of the bank and a marketable security
Dollar-denominated deposits at foreign banks or foreign branches of American banks.
Pay higher interest rate than U.S. Deposits
Repurchase agreements (repos)
short-term sales of securities with an agreement to repurchase the securities at a higher price.
the dealer sells securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price.
RP is a collateralized loan; many RPs are overnight, though "term" RPs may have a 1-month maturity
Reverse RP is lending money and obtaining security title as collateral
"Haircuts" may be required, depending on collateral quality
individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it. The rate paid on such loans is usually about one percentage point higher than the rate on short-term T-bills.
call money rate applies for investors buying stock on margin
Loan may be "called in" by broker
funds in the accounts of commercial banks at the Federal Reserve Bank.
depository institutions must maintain deposits with Federal Reserve bank
Federal funds-trading in reserves held on deposit at Federal Reserve
Key interest rate for economy
Federal Funds Rate
In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate is an important benchmark in financial markets.
London Interbank Offer Rate (LIBOR)
lending rate among banks in the London market.
Is the rate at which large banks in London are willing to lend money among themselves.
This rate has become the premier short-term interest rate quoted in the European money market and serves as a reference rate for a wide range of transactions
Yields on Money Market Instruments
Although most money market securities are of low risk, they are not risk-free. The securities of the money market promise yields greater than those on default free T-bills, at least in part because of their greater relative risk.
also known as equity securities, or equities, represent ownership shares in a corporation. Each share of common stock entitles its owners to one vote on any matters of corporate governance put to a vote at the corporation's annual meeting and to share in the financial benefits of ownership.
Characteristics of common stock
Residual claim- means stockholders are the last in line of all those who have a claim on the assets and income of the corporation
Limited Liability- means that the most shareholders can lose in event of the failure of the corporation is their original investment.
nonvoting shares in a corporation, usually paying a fixed stream of dividends.
is an equity investment.
are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock.
American Depository Receipts (ADRs)
are certificates traded in U.S. markets that represent ownership in shares of a foreign company.
Were created to make it easier for foreign firms to satisfy U.S. security registration requirements
They are the most common way for U.S. investors to invest in and trade the shares of foreign corporations.
Stock Market Indexes
measures of what is happening to a given set of stock prices for a specified list of companies; the most well known is the Dow Jones Industrial Average
Dow Jones Average
the Dow Jones Industrial Average (DJIA) of 30 large, "blue-chip" corporations has been computed since 1896. Its long history probably accounts for its preeminence in the public mind.
originally, the DJIA was calculated as the average price of the stocks included in the index. So, if there were 30 stocks in the index, one would add up the prices of the 30 stocks and divide by 30. The percentage change in the DJIA would then be the percentage change in the average price of the 30 shares. The procedure means that the percentage change in the DJIA measures the return on a portfolio that invests one share in each of the 30 stocks in the index
Price- weighted average
an average computed by adding the prices of the stocks and dividing by a "divisor"
The Dow measures the return on a portfolio that holds one share of each stock. The amount of money invested in each company in that portfolio is therefore proportional to the the company's share price, so the Dow is an example of price-weighted index.
Standard & Poor's Indexes
The Standard & Poor's Composite 500 stock index represents an improvement over the Dow Jones averages in 2 ways. First, it is a more broadly based index of 500 firms. Second, it is a market value-weighted index.
The S&P 500 is computed by calculating the total market value of the 500 firms in the index and the total market value of those firms on the previous day of trading. The percentage increase in the total market value from one day to the next represents the increase in the index.
Market value-weighted index
Index return equals the weighted average of the returns of each component security, with weights proportional to outstanding market value.
Other U.S. Market Value Indexes
Equally Weighted Index
An index computed from a simple average of returns.
Do not correspond to buy-and-hold portfolio strategies.
Foreign and International Stock Market Indexes
Nikkei (Japan), FTSE (U.K.), DAX (Germany), Hang Seng (Hong Kong), and TSX (Toronto).
A leader in the construction of international indexes has been MSCI, which computes over 50 country indexes and several regional indexes.
the right to buy an asset at a specified price on or before a specified expiration date.
Ex: An October call option on Apple stock with exercise price $100 entitles its owner to purchase Apple Stock for a price of $100 at any time up to and including the option's expiration date in October.
The holder of the call need not exercise the option; it will make sense to exercise only if the market vale of the asset that may be purchased exceeds the exercise price
The right to sell an asset at a specified exercise price on or before a specified expiration date.
Ex: An October put on Apple with exercise price $100 entitles its owner to sell Apple stock to the put writer at a price of $100 at any time before expiration in October, even if the market price of Apple is lower than $100
The put is exercise only if its holder can deliver an asset worth less than the exercise price in return for the exercise price.
Money Market Instruments
treasury bills, certificates of deposit, commercial paper, bankers' acceptances, eurodollars, repos and reverses, brokers' funds, federal funds, LIBOR (London Interbank Offer Rate)
preferred/common dividends not tax-deductible to issuing firm; corporate tax exclusions on 70% of dividends earned
market for new issues of securities
investment bankers who market a firm's securities to the public act as brokers; they seek investors to purchase securities directly from the issuing corporation
New issue created/sold
Key factor: Issuer receives proceeds from sale
Public offerings: Registered with SEC; sale made to investing public
Private offerings: Not registered; sold only to limited number of investors with restrictions on resale
market for already-existing securities
Existing owner sells to another party
Issuing firm doesn't receive proceeds, is not directly involved
Primary offerings in which shares are sold directly to a small group of institutional or wealthy investors
Privately Held Firms
owned by a relatively small number of shareholders.
have fewer obligations to release financial statements and other information to the public.
Initial Public Offering (IPO)
First public sale of stock by a formerly price company
Investment bankers manage the issuance of new securities to the public. Once the SEC has commented on the registration statement and a preliminary prospectus has been distributed to interest investors, the investment bankers organize road sows in which they travel around the country to publicize the imminent offering. They have two purposes. One, they generate interest among potential investors and provide information about the offering. Second, they provide information to the issuing firm and its underwriters about the price at which they will able to market the securities.
Seasoned Equity Offering
The sale of additional shares in firms that already are publicly traded
For example, a sale by Apple of new shares of stock would be considered a seasoned new issue.
Underwriters purchase securities from the issuing company and resell them to the public
Public offerings of both stock and bonds typically are marketed by investment bankers who have this role.
A description of the firm and the security it is issuing.
At this point, the price at which the securities will be offered to the public is announced
An important innovation in the issuing of securities was introduced in 1982 when the SEC approved Rule 415, which allows firms to register securities and gradually sell them to the public for two years following the initial registration. Because the securities are already registered, they can be sold on short notice, with little additional paperwork. Moreover, they can be sold in small amounts without incurring substantial floatation costs. The securities are "on the shelf", ready to be issued, which has given rise to the this term.
Direct Search Markets
is the least organized market. Buyers and sellers must seek each other out directly. An example of a transaction in such a market is the sale of a used refrigerator where the seller advertises for buyers on Craigslist. Such markets are characterized by sporadic participation and nonstandard goods. It would not pay for most people or firms to specialize in such markets
In markets where trading in a good is active, brokers find it profitable to offer search services to buyers and sellers. A good example is the real estate market where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to conduct the searches.
Markets in which traders specializing in particular assets buy and sell for their own accounts.
Dealers specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory. The spreads between dealers' buy and sell prices are a source of income
A market where all traders meet at one place to buy or sell an asset
The NYSE is an example
An advantage of this over dealer markets is that one need not search across dealers to find the best price for a good.
The price at which a dealer or other trader is willing to purchase a security.
the price at which a dealer or other trader will sell a security
the difference between the bid and asked prices.
Limit Buy (sell) Order
An order specifying a price at which an investor is willing to buy or sell a security
May instruct the broker to buy some number of shares if and when they may be obtained at or below a stipulated price
instructs the broker to sell if and when the stock price rise above a specified limit.
Trade is not to be executed unless stock hits a price limit
Over-the-counter (OTC) Market
An informal network of brokers and dealers who negotiate sales of securities.
Roughly 35,000 securities trade on this market. Thousands of brokers register with the SEC as security dealers. Dealers quote prices at which they are willing to buy or sell securities. A broker then executes a trade by contacting a dealer listing an attractive quote.
NASDAQ Stock Market
The computer-linked price quotation and trade execution system
Computer-linked price quotation system for OTC market
allows for electronic execution of trades at quoted prices without the need for direct negotiation, and the vast majority or trades are executed electronically
Electronic Communication Networks (ECNs)
computer networks that allow direct trading without the need for market maters.
Allows participants to post market and limit orders over computer networks.
They are true trading systems, not merely price quotation systems
Are attractive because of the speed with which a trade can be executed.
These systems offer investors considerable anonymity in their trades
A trader who makes a market in the shares of one or more firms and who maintains a "fair and orderly market: by dealing personally in the market
Secondary markets where already-issued securities are bought and sold by members.
NYSE is the largest U.S Stock exchange
the time it takes to accept, process, and deliver a trading order
buy/sell at specified price or better
Limit buy/sell order
specifies price at which investor will buy/sell
Functions of Financial Markets
Overall purpose: Facilitate low-cost investment
Bring together buyers and sellers at low cost
Provide adequate liquidity by minimizing time and cost to trade and promoting price continuity
Set and update prices of financial assets
Reduce information costs associated with investing
The use of computer programs to make rapid trading decisions.
many of these trades exploit very small discrepancies in security prices and entail numerous and rapid cross-market price comparisons that are well suited to computer analysis.
A subset of algorithmic trading that relies on computer programs to make very rapid trading decisions.
High frequency traders compete for trades hat offer very small profits. But if those opportunities are numerous enough, they can accumulate big money.
Electronic trading networks where participants can anonymously buy or sell large blocks of securities.
Not only are buyers and sellers in them hidden from the public, but even trades may not be reported, or if they are reported, they may be lumped with other trades to obscure information about particular participants
large transactions in which at least 10,000 shares of stock are bought or sold
Globalization of Stock Markets
Moving to automated electronic trading
Current trends will eventually result in 24-hour global markets
Moving toward market consolidation
Commission: fee paid to broker for making transaction
Spread: Cost of trading with dealer
-Bid: price at which dealer will buy from you
-Ask: Price at which dealer will sell to you
Spread: (Ask - Bid)
Combination: On some trades both are paid
Describes securities purchased with money borrowed in part from a broker. The margin is the net worth of the investor's account
All securities purchased on margin must be maintained with the brokerage firm in street name, for the securities are collateral for the loan
Initial Margin Requirement (IMR)
Minimum set by Federal Reserve under Regulation T, currently 50% for stocks
Minimum % initial investor equity
1 − IMR = Maximum % amount investor can borrow
Position value - borrowing + additional cash
Maintenance Margin Requirement (MMR)
Minimum amount equity can be before additional funds must be put into account
Exchanges mandate minimum 25%
notification from broker that you must put up additional funds or have position liquidated
Margin (equity)/ Value of Account (revenue)
the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan.
It allows investors to profit from a decline in security's price.
An investor borrows a share of stock from a broker and sells it. Later, the short-seller must purchase a share of the same stock in order to replace the share that was borrowed (Covering the short position).
the short-seller anticipates the stock price will fall, so that the share can be purchased later at a lower price than it initially sold for; if so, the short-seller will reap a profit.
Short-sellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale.
covering or closing out position
buy stock; broker returns title to party from which it was borrowed
Short Sale Equity
= Total margin account - Market Value
Short Sales (Round Trips)
-Buy first, sell later
-Sell first, buy later
"Round trip" is a purchase and a sale
Regulations of Securities Markets
The Sarbanes-Oxley Act
nonpublic knowledge about a corporation possessed by corporate officers, major owners, or other individuals with privileged access to information about the firm
Which of the following is not a money market security?
a. 15 day U.S. Treasury Bill
b. 2 year Treasury Note
c. 3 month Banker's Acceptance
d. 6 month Bank CD
b. 2 year Treasury Note
Common stock is an example of a ____________________ asset.
The typical fee charged by firms that help private companies go public is ______% if the sale proceeds.
Higher the risk, higher the ____________
The rate at which banks typically borrow/lend for a short period (overnight) is called the _________
a. Federal Funds Rate
b. LIBOR rate
c. Discount rate
d. Prime Rate
a. Federal Funds Rate
Which one of the following is a true statement?
a. Dividends on preferred stocks are tax-deductible to individual investors but not to corporate investors
b. Common dividends cannot be paid if preferred dividends are unpaid on cumulative preferred stock
c. Preferred stockholders have voting power
d. Investors can sue managers for nonpayment of preferred dividends
b. Common dividends cannot be paid if preferred dividends are unpaid on cumulative preferred stock
An example of an Equally Weighted Index is the _________ index
The NYSe has a system where every stock is monitored for "Fair and Orderly Trading". The person/firm that is responsible for this is called a ___________
If you saw the following quotes for Amazon Stock:
Bid- $2005.15 Ask- $2005.17
Which of these prices would be applied to you if you were looking to sell one share of Amazon stock?
What is an ECN- expand and briefly explain
Electronic Communications Network
Trading platform that eliminates the need for brokers
What is an ADR- Expand and briefly explain why it is beneficial to U.S. investors. Why is it beneficial to foreign firms
American Depository Receipt
Beneficial to U.S. investors because it allows them to trade safely in foreign firms
Foreign firms get access to U.S. Capital markets
Why are short-sellers beneficial to the efficiency of capital markets?
First line of defense against fraud and overvaluation
balance the bullish bias in capital markets
You purchased 500 shares of TopBox Inc. on margin at $58 per share. Assume the initial margin is 50% and the maintenance margin is 30%. You will get a margin call if the stock drops below _____________.
Maintenance margin: 30% or 0.3
Cost of Shares: 500 x $58 = $29,000
Loan 50% = $14,500
Margin 50% = $14,500
account value= shares x p
To Compute margin call price:
[account value] - [loan + i]/ [account value] = 0.3
500p - $14,500/ 500p = 0.3
500p - $14,500 = (0.3 x 500p)
500p -$14,500 = 150p
350p = $14,500
p= $41.43 or lower
Expand and briefly explain the following- IPO, SEO, Secondary Equity Offering
IPO: initial public offering. The first time a firm issues stock to the public
SEO: Seasoned equity offering. The 2nd, 3rd, ... nth time a public firm issues stock
Secondary Equity Offering: an issue by the insiders and promoters of a firm that has gone public to sell their shares. The proceeds are received by them.
List the steps involved in a short-sale.
1. Investor requests broker to set up short-sale account
2. Broker shorts the shares and places proceeds in the account. These shares are borrowed from another investor.
3. Short seller brings margin (at least 50% of sale proceeds)
4. if the stock price increases (decreases), the investor loses (gains).
5. To close the account, the investor "buys- to- cover"
6. Investor receives profits, or takes losses
7. If dividends were paid during the process, the short seller is responsible for paying that amount.
When is short-sale illegal? What is the name given to this type of illegal transaction? Why can it be very difficult to detect?
Illegal: when the shares shorted do not exist. Not borrowed/ not owned by the seller
Naked Short Selling
Difficult to detect because of T+3 trading/settlement rule. A person who sells shares on Monday can buy it back by Wednesday (essentially netting off their position). No deliver of shares is required.
Capital Asset Pricing Model (CAPM)
A model that relates the required rate of return on a security to its systemic risk as measured by beta.
Predicts the relationship we should observe between the risk of an asset and its expected return. This relationship serves two vital functions. First, it provides a benchmark rate of return for evaluating possible investments. Second, the model helps us make an educated guess as to the expected return on assets that have not yet been traded in the marketplace.
the exploitation of security misprision to earn risk-free economic profits.
market portfolio (M)
the portfolio for which each security is held in proportion to its total market value
Includes all assets of the security universe. (Assets = stocks)
risk premium formula
E(Rm) - Rf
Mutual Fund Theorem
States that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual find composed of that portfolio
Expected return-beta relationship:
implication of the CAPM that security risk premiums (expected excess returns) will be proportional to beta
E(rD)= rf + BD[E(rM)- rf]
makes a powerful economic statement. It implies, for example, that a security with a high variance but a relatively low beta of .5 will carry one-third the risk premium of a low-variance securing with a beta of 1.5
Security Market Line (SML)
Graphical representation of the expected return-beta relationship of the CAPM.
Its slope is the risk premium of the market portfolio
graphs individual-asset risk premiums as fiction of asset risk (which we measure by beta).
valid for both for individual assets and portfolios.
provides a benchmark for evaluation of investments performance
provides the required rate of return that will compensate investors for the beta risk of that investment, as well as for the time value of money
Whenever the CAPM holds, all securities lie on the SML. Underpriced stocks plot above the SML: Given beta, their expected returns are greater than is indicated by the CAPM. Overpriced stocks plot blow the SML.
the abnormal rate of return on a security in excess of what would be predicted by an equilibrium model such as the CAPM
the difference between fair and actual expected rates of return on a stock.
Single Index Model
A model of stock returns that decomposes influences on returns into a systematic factor, as measured by the return on a broad market index, and firm-specific factors.
= Risk-free rate + B x Expected excess return of index
= rf + B(rM- rf)
Models of security returns that respond to several systematic factors
can provide better descriptions of security returns
Fama-French Three-Factor Model
A factor model that expands on the capital asset pricing model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM. This model considers the fact that value and small cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance. I: Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or value stocks would be lower than the CAPM result, as the three factor model adjusts downward for small cap and value outperformance.There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts.
Fama-French Three-Factor Model
Includes one factor for the excess market return (the market return minus the risk free rate), a second factor for size (defined as the return on a portfolio of small firms minus the return on a portfolio of big firms), and a third factor for the book-to-market effect (defined as the return on a portfolio of firms with a high book-to-market ratio minus the return on a portfolio of firms with a low book-to-market ratio).
Creation of diskless profits made possible by relative misplacing among securities
Arbitrage Pricing Theory (APT)
A theory of risk-free return relationships derived from no-arbitrage considerations in large capital markets
the act of exploiting mispricing of two or more securities to achieve risk-free profits.
a portfolio sufficiently diversified that nonsystematic risk is negligible
a portfolio with practically negligible residual risk
a zero-net-investment, risk-free portfolio with a positive return
a well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of zero on any other factor
individual investors are price takers
single-period investment horizon
investments are limited to traded financial assets
no taxes and no transaction costs
information is costless and available to all investors
investors are rational mean-variance optimizers
Resting Equilibrium Conditions
All investors will hold the same portfolio for risky assets; the "market portfolio"
Market portfolio contains all securities and the proportion of each security is its market value as percentage of total market value
Market price of risk or return per unit of risk depends on the average risk aversion of all market participants
Slop and Market Risk Premium
M = market portfolio
rf = risk free rate
E(rM) - rf = excess return on the market portfolio
Expected Return and Risk on Individual Securities
Individual security's contribution to the risk of the market portfolio is a function of the covariance of the stock's returns with the market portfolio's returns and is measured by BETA
can be reduced to an arbitrary low level through diversification; therefore, investors do not require a risk premium compensation for bearing nonsystematic risk. They need to be compensated only for bearing systematic risk, which cannot be diversified
Slope of CML
= E(rM) - rf/ om - o(xi)
Beta using regression
y= alpha + xB + E
y= return on stock
xB= return on market
= forecasted- required
the notion that stock price changes are random and unpredictable
Efficient Market Hypothesis (EMH)
the hypothesis that prices of securities fully reflect available information about securities
the assertion that stock prices already reflect all information contained in the history of past trading
the assertion that stock prices already reflect all publicly available information
the assertion that stock prices reflect all relevant information, including inside information
research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market
a price level above which it is supposedly unlikely for a stock or stock index to rise
a price level below which it is supposedly unlikely for a stock or stock index to fall
research on determinants of stock value, such as earnings and dividend prospects, expectations for future interest rates, and risk of the firm
it represents an attempt to determine the present discounted value of all the patients a stockholder will receive from each share of stock. If that value exceeds the stock price, the fundamental analyst would recommend purchasing the stock
passive investment strategy
buying a well-diversified portfolio without attempting to search out mispriced securities
aims only at establishing a well-diversified portfolio of securities without attempting to find under or overvalued stocks.
a mutual fund holding shares in proportion to their representation in a market index such as the S&P 500
a fund designed to replicate the performance of a broad-based index of stocks.
the tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods
the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period
patterns of returns that seem to contradict the efficient market hypothesis
portfolios of low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks
stocks of small firms have earned abnormal returns, primarily in the month of January
the tendency of investments in stock of less well-known firms to generate abnormal returns
the tendency for investments in shares of firms with high ratios of book value to market value to generate abnormal returns
stock prices are random
randomly evolving stock prices are the consequence of intelligent investors competing to discover relevant information
expected price is positive over time
positive trend are random about the trand
Random price changes
Why are price changes random?
-prices react to information
-flow of information is random
-therefore, price changes are random
EMH and Competition
stock prices fully and accurately reflect publicly available information
once information becomes available, market participants analyze it
competition assures prices reflect information
using prices and volume information to predict future prices
- weak form efficiency & technical analysis
using economic and accounting information to predict stock prices
-semi strong from efficiency & fundamental analysis
Implications of efficiency for Active or Passive Management
- security analysis
-buy and hold
The Role of Portfolio Management in an Efficient Market
Even if the market is efficient a role exists for portfolio management:
-Appropriate risk level
Weak-Form Tests: Patterns in Stock Returns
Returns over short horizons
- very short time horizons small magnitude of positive trends ( + + - ++ - +)
- 3-12 month some evidence of positive momentum
Returns over long horizons- pronounced negative correlation
Evidence on reversals (mean reversion)
Predictors of Broad Market Returns
Fama and French
-aggregate returns are higher with higher dividend ratios
Campbell and Shiller
-earnings yield can predict market returns
Keim and Stambaugh
-bond spreads can predict market returns
Semi-Strong Tests: Market Anomalies
Small Firm Effect (January Effect- anomaly)
-invest in low capitalization stocks
-earn excess returns
Neglected Firm/Orphan Firms
-small firms tend to be neglected by large institutional traders
-Beta seems to have no power to explain average security returns
Post-Earnings Announcement Drift
-There is a large abnormal return on the earnings announcement day
Strong-Form Tests: Inside Information
The ability of insiders to trade profitability in their own stock has been documented in studies Jaffe, Seyhun, Givoly, and Palmon
SEC requires all insiders to register their trading activity
Interpreting the Evidence
Risk Premiums or market inefficiencies- disagreement here
-Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas
-Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets
Anomalies or Data Mining
-Rerun the computer database of past returns over and over and examine stock returns along enough dimensions:
- simple chance may cause some criteria to
appear to predict returns
stock market analysis
Do analysts add value- mixed evidence
- Womack study found that positive changes are associated with increased stock prices of about 5%
-Negative changes result in average price decreases of 11%
-Are prices change due to analysts' information or through pressure brought on by the recommendations themselves
models of financial markets that emphasize potential implications of psychological factors affecting investor behavior
investors are too slow (too conservative) in updating their beliefs in response to recent evidence
people are too prone to believe that a small sample is representative of a broad population and infer patterns too quickly
decisions are affected by how choices are posed, for example, as gains relative to a low baseline level or losses relative to a higher baseline
a specific form of framing in which people segregate certain decisions
people blame themselves more for unconventional choices that turn out badly so they avoid regret by making conventional decisions
behavioral theory that investor utility depends on gains or losses from investors' starting position, rather than on their levels of wealth
Limits to arbitrage
fundamental risk, implementation costs, model risk
Limits to Arbitrage and Law of One Price
"Siamese Twin" Companies
refers to the tendency of investors to hold on to losing investments
The average price over a given interval, where that interval is updated as time passes
For example, a 50-day moving average traces the average price over the previous 50 days.
the average is recomputed each day by dropping the oldest observation and adding to the news.
the extent to which movements in broad market indexes are reflected widely in movements of individual stock prices
recent performance of a given stock or industry compared to that of a broader market index
measures the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry
computed by calculating the ratio of the price of the security to a price index for the industry
the ratio of average volume in declining issues to average volume in advancing issues
= (volume declining/number declining)/(volume advancing/number advancing)
ratio of the yield of top-rated corporate bonds to the yield on intermediate-grade bonds
ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds
the total number of shares currently sold short in the market
some technicians interpret high levels of short interest as bullish, some as bearish. The bullish perspective is that, because all short sales must be covered, short interest represents latent future demand for the stocks. As short sales are covered, the demand created by the share of purchase will force prices up. The bearish interpretation of short interest is based on the fact that short-sellers tend to be larger, more sophisticated investors
ratio of put options to call options outstanding on a stock
put options do well in falling markets while call options do well in rising markets
Investors do not always process information correctly
Investors often make inconsistent or systematically suboptimal decisions
Information Processing Technique
Sample size neglect and representativeness
framing, mental accounting, regret avoidance, prospect theory
Bubbles and Behavioral Economics
Evidence of irrational investor behavior
Easier to identify once over
Evaluating Behavioral Critique
-No coherent theory
-Most empirical support from one time period: late '90s
-Arguments that the evidence does not support one type of irrationality
Although the ability to discern apparent patterns with stock market prices is irresistible- it is also possible to perceive patterns that may not exist
If the "price line" cuts the "moving average" from below and moves above it, that would be considered a ______ signal.
In the context of the capital asset pricing model, the measure of total risk is _________.
a. the federal funds rate
b. the beta
c. the standard deviation
e. none of the above
c. the standard deviation
In a well-diversified portfolio, __________ risk is negligible (almost zero).
Solve the following using the CAPM model. The risk-free rate is 5% and the expected return on the market is 15%. What is the beta on a stock with an expected return of 17%?
According to the capital asset pricing model, the forecasted returns on undervalued securities will plot ________.
a. above the security market line
b. on the security market line
c. below the security market line
d. none of the above
a. above the security market line
You have a $100,000 portfolio consisting of AAPL, Cisco and 3M. You invest $40,000 in AAPL, $24,000 in Cisco and the rest in 3M. AAPL, Cisco and 3M have betas of 1.1, 0.6, and 0.7 respectively. What is your portfolio beta?
e. none of the above
If the TRIN ratio is 0.85, that would be considered a ________ signal
Consider the CAPM. The expected return on the market is 18%. The expected return on a stock with a beta of 1.2 is 20%. What is the risk-free rate?
e. none of the above
Choosing stocks by searching predictable patterns in stock prices, using historic price and volume is called ________.
A. fundamental risk
b. technical analysis
c. index management
d. random walk investing
b. technical analysis
Research has shown that on average, long term stock price movements follow a _______ ______ with a ________ _______. The technical term for this is a "sub-martingale"
random walk, positive drift
What does "prospect theory" help us understand?
If a trader/investor loses money initially, then they become/trade in a more risky manner to get back what they have lost. Given that the slope is steeper to the right, they can get more satisfaction from gaining another dollar than losing another dollar.
List or very briefly explain two "Limits to Arbitrage".
fundamental risk, implementation cost, model risk
What are anomalies (as pertains to the EMH). List and briefly explain two.
Anomalies are those strategies that allow/have allowed investors to beat the market (unexplained by the EMH).
1. B/M (if high ----> ELR) Also high
2. Portfolio of orphan stocks ----> tend to outperform
3. Winners keep winning (in the short term); losers keep losing
4. Long run mean reversals
The Cauldron Company, has a forecasted rate of return of 12% and a beta of 1.10. The market expected rate of return is 8% and the risk-free rate is 5%. The alpha of the stock is _________.
e. none of the above
To guide you in ranking potential investment if you want to invest without diversifying. Select the one with the highest sharpe
Rank potential investments by this if you are looking to add a security to an already well diversified portfolio.
Does the following graph showing the average reaction to stock price movements over 90 days from an earnings surprise date, show support for, or argue against the EMH? Why?
Against - the prices move in the correct direction before the news reaches the market
Against- prices do not level off even after 90 days --> still reacting to the news
For- prices level off quickly/ information is absorbed quickly
A high "short interest" ratio can be both a bullish and bearish signal for an investor. Why?
Bearish: the "smart money" is betting that the price will fall
Bullish: short-squeeze/ breaking the shorts. if something unexpected causes the price to jump a little, it will spike a lot as short sellers rush to buy-to-cover.
the net worth of common equity according to a firm's balance sheet
net amount that can be realized by selling the assets of a firm and paying off the debt
cost to replace a firm's assets
ratio of market value of the firm to replacement cost
the present value of a firm's expected future net cash flows discounted by the required rate of return
market capitalization rate
the market-consensus estimate of the appropriate discount rate for a firm's cash flows
Dividend Discount Model (DDM)
a formula for the intrinsic value of a firm equal to the present value of all expected future dividends
Constant Growth DDM
a form of the dividend discount model that assumes dividends will grow at a constant rate
Dividend payout ratio
percentage of earnings paid out as dividends
plowback ratio or earnings retention ratio
the proportion of the firm's earnings that is reinvested in the business (and not paid out as dividends)
Present Value of Growth Opportunities (PVGO)
net present value of a firm's future investments
the ratio of a stock's price to its earnings per share
ratio of P/E multiple to earnings growth rate
the practice of using flexibility in accounting rules to manipulate the apparent profitability of the firm
Basic Types of Models
Balance sheet models
Dividend discount models
book value, market value, liquidation value, replacement cost
Vo = Summ( Dt/ 1 +K)^t
No Growth Model
Vo = D/k
Constant Growth Model
Vo = Do(1+g)/ k-g
growth rate in dividends
g = ROE x b
g- growth rate in dividends
ROE- return on equity for the firm
b- plowback or retention percentage rate
(1- dividend payout percentage rate)
Present value of Growth opportunities
if the stock price equals its IV, growth rate is sustained, the stock should sell at:
if all earnings paid out as dividends, price should be lower (assuming growth opportunities exist)
= no-growth value per share + PVGO
Comparative valuation ratios
Free Cash Flow
One approach is to discount the free cash flow for the firm (FCFF) at the weighted-average cost of capital
subtract existing value of debt
FCFF = EBIT (1 - tc)
EBIT = earnings before interest and taxes
tc= the corporate tax rate
NWC= net working capital
Another approach focuses on the free cash flow to the equity holders (FCFE) and discounts the cash flows directly at the cost of equity