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Investments Exam 2
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Terms in this set (72)
Market/Systematic/Nondiversifiable Risk
Risk factors common to the whole economy
Unique/Firm-specific/Nonsystematic Risk
Risk that can be eliminated by diversification
Rate of return on a portfolio
Weighted average of returns on the component securities, with the investment proportions as weights.
Expected rate of return on a portfolio
Weighted average of the expected returns on the component securities, with the portfolio proportions as weights.
Investment Opportunity Set
The set of all attainable combinations of risk and return offered by portfolios
Efficient Frontier
Graph representing a set of portfolios that maximizes expected return at each level of portfolio risk
Separation Property
The property that implies portfolio choice can be separated into two independent tasks
Tasks of Separation Property
Determination of the optimal risky portfolio and the personal choice of the best mix of the risky portfolio and the risk-free asset.
Index Model
Model that relates stock returns to returns on both a broad market index and firm-specific factors
Excess Return
Rate of return in excess of the risk-free rate.
Firm-Specific/Residual Risk
Component of return variance that is independent of the market factor.
Alpha
A stock's expected return beyond that induced by the market index; its expected excess return when the market's excess return is zero.
Variance
Systematic Risk+Firm-specific Risk
Security Characteristic Line
Plot of a security's predicted excess return from the excess return of the market.
Information Ratio
Ratio of alpha to the standard deviation of the residual
Number of stocks in a portfolio eliminating naive diversification
At least 25
Correlation coefficient with regards to returns
Smaller correlation coefficients will yield higher returns
Capital Market Line
Optimal CAL that extends from risk free rate to the tangency point on the efficient frontier
Sharpe Ratio
Risk premium divided by standard deviation
Optimal Risky Portfolio
The best combination of risky assets to be mixed with safe assets to form the complete portfolio.
Beta
The sensitivity of a security's returns to the market factor. Measure of stock's systematic risk.
Slope in graph of stock returns to market returns.
Active Portfolio
The portfolio formed by optimally combining analyzed stocks.
Correlation Coefficient=1/-1
Securities perfectly positively/negatively correlated
Price of risk
Risk premium divided by variance
Single Index Model Parameters
Beta - effect of market
Alpha - excess return unrelated to market
Standard Deviation - random variations due to firm specific events
Change in Sharpe Ratio
(alpha/Standard deviation)^2
Capital Asset Pricing Model (CAPM)
A model that relates the required rate of return on a security to its systematic risk as measured by beta
Market Portfolio (M)
The portfolio for which each security is held in proportion to its total market value.
Mutual Fund Theorem
All investors desire the same portfolio of risk assets and can be satisfied by a single mutual fund composed of that portfolio.
CAPM Assumptions
Markets are perfectly competitive and equally profitable.
All investors choose investments in the same manner.
CAPM Implications
All investors will choose to hold the market portfolio. (not true)
There is one unique market-wide price of risk
The risk premium is a function of the security's contribution to the risk of the market.
Alpha Equation
Expected return - Required return
Capital Gain Yield
Expected return - Dividend yield
Expected Return-Beta Relationship
Implication of the CAPM that security risk premiums will be proportional to beta
Security Market Line
Graphical representation of the expected return-beta relationship of the CAPM
Residual
Actual return-Predicted return
t-statistic
(Estimated Value-Hypothesis Value)/Standard error of estimate
Multifactor Models
Models of security returns that respond to several systematic factors.
Arbitrage
Creation of riskless profits made possible by relative mispricing among securities.
Arbitrage Pricing Theory
A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets.
Well-diversified portfolio
A portfolio sufficiently diversified that nonsystematic risk is negligible.
Fama and French Factors
Market index excess return
Ratio of the book value of equity to market value
Difference in returns between small and large firms
Factor Portfolio
A well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of 0 on any other factor
Advantages of Arbitrage over CAPM
Easily extended to multiple systematic factors
Employs fewer restrictive assumptions
Does not require any specific role for the market portfolio
Predicting future betas
Adjust estimates from historical data to account for regression towards 1.0
CAPM in real world
False based on assumptions, untestable
Useful as predictor of returns
Arbitrage vs CAPM
APT applies to portfolios, not individual stocks (mispricing)
APT more general
Random Walk
Notion that stock price changes are random and unpredictable.
Efficient Market Hypothesis
Prices of securities fully reflect available information.
Why prices are random
Flow of information is random, and prices react to flow
Weak-form EMH
Assertion that stock prices already reflect all information contained in the history of past trading
Semistrong-form EMH
Assertion that stock prices already reflect all publicly available information
Strong-form EMH
The assertion that stock prices reflect all relevant information, including inside.
Technical Analysis
Research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market.
Resistance Level
A price level above which it is supposedly unlikely for a stock or stock index to rise.
Reasons Market Efficiency is questioned
Investors have unequal information
Structural market problems that prevent arbitrage
Prevalence of psychological factors among investors
Support Level
A price level below which it is supposedly unlikely for a stock or stock index to fall
Fundamental Analysis
Research on determinants of stock value, such as earnings and dividend prospects, expectations for future interest rates and risk of the firm
Passive Investment Strategy
Buying a well-diversified portfolio without attempting to search out mispriced securities.
Index Fund
A mutual fund holding shares in proportion to their representation in a market index.
Issues with Market Efficiency
Magnitude
Selection Bias
The lucky Event
Momentum Effect
The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
Reversal Effect
Tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period.
Anomalies
Patterns of returns that seem to contradict the efficient market hypothesis.
Price-Earnings Effect
Portfolios of low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks
Small-firm effect
Stocks of small firms have earned abnormal returns, primarily in January.
Neglected-firm effect
The tendency of investments in stock of less well-known firms to generate abnormal returns.
Book-to-Market effect
Tendency for investments in shares of firms with high ratios of book value to market value to generate abnormal returns
Campbell and Shiller results
Aggregate returns tend to be higher for firms with higher earnings yields
Rendleman, Jones and Latane results
Firms with superior earnings tend to have abnormal stock returns after earnings are announced
Problems with bubbles
Difficult to predict
Prices eventually conform to intrinsic value
Prices are estimates of future performance, and can change rapidly.
Risk premiums can change rapidly
Anomalies that contradict market efficiency
Book to Market Ratios
Long term reversals
Small firm in January effect
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