Portfolio Theory
CAPM
Shareholders
Debt
Government
100
What is diversification and what is diversification benefit?
Diversification benefit is a result of correlation. When we have more than one asset in a portfolio, we want them to be less than positively correlated because positive correlation means that they are redundant. Mathematical expected return and standard deviation are parameters of Mkwtz portfolio theory  3 is correlation between assets in the portfolio helps to determine the extent to which the mix of assets in the portfolio will affect the returns  point of correlation is to get diversification benefit The more negatively correlated they are, the more diversification benefit they get When you have 2 assets going opposite directions in a portfolio, the effect is added stability. The characteristics of the individual assets doesn’t change, the variance does. Different assets stabilize the variation of the portfolio and give a standard deviation or variance of 0.
100
Define unique risk, market risk, total risk, and beta. What does CAPM calculate? What affects beta's magnitude (3 things)?
unique risk: diversifiable risk (can be diversified away) market risk: nondiversifiable risk (cannot be diversified away) total risk: unique risk + market risk beta: measures how much additional risk the addition of an asset will add to the portfolio CAPM calculates expected return on a given stock Factors that affect Beta's magnitude: cyclical sensitivity financial leverage (debt increases risk) operating leverage (ratio of fixed costs to total costs)
100
What does equity mean? What do shareholders own?
ownership shareholders own nothing more than a claim of the profits generated by the company - all they really own is their share
100
Debt and equity are both capital, but some religions condemn interest. why?
The historical image of little folk borrowing resulted in the retention of interest rate ceilings – faulty premise that equity is real capital and debt is not  they are both real capital. Debt thought of as exploiting people in need.
100
Since debt allows companies to subtract interest expenses from taxes (so debt is technically subsidized), doesn't this affect company decisions?
yup! Whenever you subsidize something, people use more of it than they otherwise would have (ex: free ice cream). Debt allows companies to reduce tax liability  subsidy
200
How is the annual return on a stock measured?
Cash flows (dividend) + capital gain (asset increase or decrease in market value over the holding period)/original price of asset So how would you determine a percentage return? Relate the dividend to the price you bought the stock at You pay $10 for stock and got $1 dividend and market price went up $2 - $3 in income, which is a 30% increase “Yield” or “return” – in terms that will allow you to compare across different assets Only way to compare stocks of different values is to calculate on a return basis  (CF+CG)/P
200
what is a "residual claimant"? what is "limited liability"?
a residual claimant means that shareholders own everything that remains after everyone else has been paid off. limited liability means that shareholders can only lose as much as they invested in the company
200
How does seniority affect the pricing of debt?
its possible that investors are willing to provide debt to companies on other terms: in event of default, how will proceeds of company’s assets be distributed? The more secure the creditor, the lower the interest rate. The less secure the creditor, the higher the interest rate. (senior = lower interest)
200
Explain the Capital Structure Irrelevance Theorem
how you use debt or equity is irrelevant – sole equity owner gets the whole thing, partial equity holders only get a piece  size doesn’t change, but individual ownership pieces change (pizza stays the same size, but people just might get smaller pieces if there are more owners).
300
How did Markowitz measure expected returns and risk on an asset in a portfolio?
Average return (mean return is the expected return). Add up historical returns on all assets and divide by the number of assets in the portfolio. How did he measure risk? Standard deviation of returns  volatility of the asset itself  the extent to which the values that we use to calculate the mean, fluctuate around the mean value (the extent to which returns fluctuate over time  less fluctuation, more confidence  essentially measures how reliable the mean is)  more volatility = more risk
300
Why do oil companies have lower betas than telecom companies?
the bulk of the risk in an oil exploration risk is unique risk (geological, exploration, etc.)  sensitive to state of economy, etc. – high beta??
300
What are the 2 ways firms can return cash to shareholders?
1. dividends: payment declared by company as a way to share profits with shareholders (set by %) or dividends per share - 1 componenet of returns expected by shareholders  also shows how well the company is doing 2. share buybacks: there is no presumption that this has to occur every year or in conjunction with dividends
300
Debt is subsidized. So why don't shareholders favor companies who exclusively hold debt?
there are numerous reasons why companies borrow – tax yield benefits valuable (low leverage in oil, high leverage in tech  tech can use debt, oil companies have subsidy and many other benefits – for oil companies to use debt as an alternative doesn’t make sense. If there is no benefit to debt, don’t take it. The more debt you take on, the higher is the cost of the debt. Higher interest rates  interest rates will rise if there is higher debt and therefore a higher perceived risk of the company There are some benefits to companies taking on debt. Unless and until you receive all interest payments, you cannot issue dividend. You no longer run the company the way you feel the company should be run, but the way the banks require that you run it in order to get paid (types and longevity of investments constraints)  in order to safeguard creditors
300
How does monetary policy attempting to stabilize the economy affect interest rates?
the Fed can affect interest rates. If the economy overheats, drain liquidity and discourage. If economy is sluggish, they can give it a boost so people will continue to buy.
400
What is the difference between the feasible set and the efficient frontier?
A feasible set is any of the possible combinations of 2 assets, ranging from 100% in asset 1 to 100% invested in asset 2. You want the combination of assets that give you the highest return for a combination of assets 1 and 2. As you take on more of the risky asset, you take on more risk and therefore get a higher return. The efficient frontier is the optimal combination of assets 1 and 2. Efficient frontier: locus of portfolios that produce the greatest returns (best combinations of assets). Anything off the frontier is inefficient and therefore will not produce the greatest amount of return for the risk incurred. The dashed line represents adding risk-free assets (bonds)  what happens when you add a risk-free asset to a risky asset (or portfolio of assets). Without risk-free assets, the best you can do is the solid line efficient frontier. Why is it upward sloping? Because you are being compensated for greater levels of risk.
400
Why did Fama and French decide it's necessary to add b/m ratio and firm size to the beta measure of CAPM? Why is it better to have a low b/m ratio than a high one?
They determined that beta is not sufficient because it only takes into account expected returns, instead of observed returns. They came up with 2 additional measures to help explain market returns: market size and book to market ratio (cost of replacing assets vs. value placed on how assets are used). lower is better than higher b/m because lower b/m means the company outperformed the market and exceeded expectations whereas high b/m means they did not do as well as expected.
400
How does tax affect how the firm chooses to return cash to shareholders?
from a tax standpoint, dividends are ordinary incomes and share buybacks are capital gains. Whichever has the lower tax rate would make more sense for the company to distribute profits that way. Companies should distribute based on lower tax rate. A firm who wants to maximize income benefit of shareholders will consider this
400
What are the principle determinants of interest rates?
idk
400
What are the Fed's main instruments of monetary control?
Open-market operations (buying and selling of gov securities – buying increases liquidation) reserve requirements (credit creation – high reserve requirements = small volumes of credit creation) discount rate (to be a lender of last resort)  supplies confidence and trust in the system.
500
Why would an investor want to invest where the CML (Capital Market Line) and the Efficient Frontier intersect? What is the significance of this point?
A feasible set is any of the possible combinations of 2 assets, ranging from 100% in asset 1 to 100% invested in asset 2. You want the combination of assets that give you the highest return for a combination of assets 1 and 2. As you take on more of the risky asset, you take on more risk and therefore get a higher return. The efficient frontier is the optimal combination of assets 1 and 2. Efficient frontier: locus of portfolios that produce the greatest returns (best combinations of assets). Anything off the frontier is inefficient and therefore will not produce the greatest amount of return for the risk incurred. The dashed line represents adding risk-free assets (bonds)  what happens when you add a risk-free asset to a risky asset (or portfolio of assets). Without risk-free assets, the best you can do is the solid line efficient frontier. Why is it upward sloping? Because you are being compensated for greater levels of risk.
500
CAPM states that beta is the only measure of risk that matters - what about the price of oil for oil companies?
of course it matters. 2 reasons oil doesn’t matter within the context of the portfolio: some stocks are sensitive to the price of oil and some are not  if upstream companies suffer, others will benefit. Oil companies struggle with lower oil prices, airlines and cars will flourish.
500
What is the implication if a firm decides to retain earnings instead of distributing them to shareholders? What if shareholders don't agree with the decision?
shareholders will be happy for the company to retain cash (to invest in company projects) within company if the company’s usage of that cash within the company produces a return higher than spending the cash. If you don’t agree with management’s decision, you sell your shares.
500
What is the magnitude of the interest deduction subsidy?
if you take the difference that the all equity has to pay in taxes from the tax liability of a company that has debt in its capital structure is the it is an interest deduction subsidy
500
Why do financial analysts believe that the shape of the yield curve is a good indicator of future economic activity?
a yield curve is a snapshot of the (gov) bond market at a moment in time - bills, bonds, and notes based on maturity. shape of yield curve comes from liquidity considerations (the more time, the less sure you are of the value of the asset)
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