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Exam 3

by: Winn

Exam 3 FIN 323

GPA 3.72

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Exam 3
Principles of Finance
Study Guide
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This 13 page Study Guide was uploaded by Winn on Monday April 4, 2016. The Study Guide belongs to FIN 323 at Marshall University taught by in Spring 2016. Since its upload, it has received 35 views. For similar materials see Principles of Finance in Business at Marshall University.


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Date Created: 04/04/16
FIN 323 : Exam 3 Study Guide Chapter 10 : Some Lessons from Capital Market History Explaining Important More Important 1) Risk-return tradeoff : Is the principle that potential return rises with an increase in risk.  Low levels of uncertainty (low-risk) are associated with low potential returns  High levels of uncertainty (high-risk) are associated with high potential returns.  According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost 2) Percent returns : 3) Permanent Portfolio Performance from 1972 to 2011 in U.S Market : About stock , bonds , cash , golds.  Average return is the simple mathematical average of a series of returns generated over a period of time.  An average return is calculated the same way a simple average is calculated for any set of numbers; the numbers are added together into a single sum, and then the sum is divided by the count of the numbers in the set (from ) 4) Risk Premiums : a) Risk-free rate : the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Example : Treasury Bills b) Risk premium : the return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment. 5) Return Variability : The statistical tools for historical returns : 6) arithmetic and geometric averages : Arithmetic mean is the sum of a series of numbers divided by the count of that series of numbers.  If you were asked to find the class (arithmetic) average of test scores, you would simply add up all the test scores of the students, and then divide that sum by the number of students. For example, if five students took an exam and their scores were 60%, 70%, 80%, 90% and 100%, the arithmetic class average would be 80%.  This would be calculated as: (0.6 + 0.7 + 0.8 + 0.9 + 1.0) / 5 = 0.8.  The reason you use an arithmetic average for test scores is that each test score is an independent event. If one student happens to perform poorly on the exam, the next student's chances of doing poor (or well) on the exam isn't affected. In other words, each student's score is independent of the all other students' scores. However, there are some instances, particularly in the world of finance, where an arithmetic mean is not an appropriate method for calculating an average Geometric mean : the average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio. Technically defined as "the 'n'th root product of 'n' numbers", the formula for calculating geometric mean is most easily written as: Where 'n' represents the number of returns in the series. The geometric mean must be used when working with percentages (which are derived from values), whereas the standard arithmetic mean will work with the values themselves 7) Efficient Capital Markets : 1. Weak-Form EMH The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid. 2. Semi-Strong EMH The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information. 3. Strong-Form EMH The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak- form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information Chapter 11 : Risk and Return Explaining Important More important 1) Expected return : The expected return (or expected gain) refers to the value of a random variable one could expect if the process of finding the random variable could be repeated an infinite number of times. 2) Variance and standard deviation : Variance (σ ) is a measure of the dispersion of a set of data points around their mean value. In other words, variance is a mathematical expectation of the average squared deviations from the mean. It is computed by finding the probability-weighted average of squared deviations from the expected value. Variance measures the variability from an average (volatility). Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on when purchasing a specific security 3) Portfolios : A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals. The risk-return tradeoff is the principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost E(R) of a portfolio = w R + w R + ...+ w R 1 1 2 q n n Portfolio standard deviation is the standard deviation of a portfolio of investments. It is a measure of variability of the expected returns from a portfolio. Portfolio Standard Deviation : 4) Systematic Risk : The risk inherent to the entire market or an entire market segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the right asset allocation strategy 5) Unsystematic Risk : Company- or industry-specific hazard that is inherent in each investment. Unsystematic risk, also known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," can be reduced through diversification. By owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type. Examples of unsystematic risk include a new competitor, a regulatory change, a management change and a product recall. 6) Total Risk = Stand-Alone risk : Standalone risk is the risk associated with a single operating unit of a company or asset. Standalone involves the risks created by a specific division or project, which would not exist if operations in that area were to cease. 7) Market risk for individual securities :  The contribution of a security to the overall riskiness of a portfolio  Relevant for stocks held in well-diversified portfolios  Measured by a stock’s beta coefficient  Measures the stock’s volatility relative to the market. 8) Interpretation of beta : Beta = 1 : indicates that the security's price will move with the market.( stock has average risk ). Beta < 1 : the security will be less volatile than the market. ( stock is less risky than average ) Beta > 1 : indicates that the security's price will be more volatile than the market. ( stock is riskier than average ) For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.  Most stocks have betas in the range of 0.5 to 1.5  Beta of the market = 1  Beta of T-bill = 0 9) Reward-to-risk ratio : a ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount he or she stands to lose if the price moves in the unexpected direction (i.e. the risk) by the amount of profit the trader expects to have made when the position is closed (i.e. the reward). 10) The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM) :


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