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essentials of investment including risk and return, efficient market hypothesis, diversification and CAPM
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Chapter 1: Introduction Investment: commitment of current resources in the expectation of deriving greater resources in the future Assets:
o Real: assets used to produce goods and services (ie land, equipment, building, knowledge) [determines the wealth of an economy]
o Financial: claims on real assets or the income generated by them (ie stocks and bonds) [represents claims on real assets]
Debt (fixed income or debt securities): pay a specified cash flow over a specific period Money market: short-term, highly marketable, and generally of very low risk (US T-bills, bank
certificates of deposit (CDs)) Capital market: long-term securities such as T-bonds, bonds issued by federal agencies, state and
local municipalities, and corporations; bonds risk ranges from default (T securities) to relatively risky (high-yield or “junk” bonds)
Equity: an ownership share in a corporation Equityholders are not promised any particular payment, but are paid dividends which is
dependent on the success of the firm Derivatives: securities providing payoffs that depend on the values of other assets (options and futures
contracts) Commodity and derivative markets allow firms to adjust their exposure to various business risks
Financial markets:o Informational roleo Consumption timingo Allocation of risko Separation of ownership and management
Avoiding agency problems: conflicts of interest between managers and stockholders Compensation plan Board of directors can force out underperforming management teams Outsiders monitor firms (security analysts and large institutional investors such as pension funds) Bad performers are subject to threats of takeover (shareholders changing board of directors)
o Corporate governance and corporate ethics Sarbanes-Oxley Act
Investment processo Asset allocation: allocation of an investment portfolio across broad asset classeso Security allocation: choice of specific securities within each asset class
Security analysis: analysis of the value of securitieso Strategies:
“top-down”: starts with the asset allocation decision – the allocation of funds across broad asset classes – and then progress to more specific security-selection decisions
“bottom-up”: constructed from the securities that seem attractively price without as much concern for the resultant asset allocation
The Market (no-free-lunch proposition)o Risk-return trade-off: assets with higher expected returns entail greater risko Efficient markets: the security price usually reflects all the information available to investors concerning the value
of the security in a quick and efficient manner Passive management: buying and holding a diversified portfolio without attempting to identify mispriced
securities Active management: attempting to identify mispriced securities or to forecast broad market trends
Players in the Financial Marketo Firms
Net demanders of capital Raise capital now to pay for investments in plant and equipment Income generated by those real assets provides the returns to investors who purchase the securities
issued by the firmo Household
Typically, suppliers of capital Purchase the securities issued by firms that need to raise funds
o Governments Borrowers or lenders, depending on relationship between tax revenue and government expenditures Has to borrow if they need to cover budget deficits (issuance of T-bills, notes and bonds)
o Financial intermediaries: institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers
pooling the resources of many small investors, they are able to lend considerable sums to large borrowers; by lending to many borrowers, intermediaries achieve significant diversification, so they can accept loans that individually might be too risky; intermediaries build expertise through the volume of business they do and can use economies of scale and scope to assess and monitor risk
investment companies: firms managing funds for investors; may manage several mutual fundso Investment bankers: firms specializing in the sale of new securities to the public, typically by underwriting the
issue Primary market: a market in which new issues of securities are offered to the public Secondary market: previously issued securities are traded among investors
o Venture capital and private equity Venture capital: money invested to finance a new firm Private equity: investments in companies that are not traded on a stock exchange
Chapter 5: Risk and Return Rates of return
o Holding-period return (HPR): rate of return over a given investment period
HPR= ending price−beginning price+cash dividendbeginning price
=dividend yield+capital gains yield
Assumption: dividends paid at the end of the holding period Dividend yield: the percentage return from dividends, cash dividends/beginning price
o Arithmetic average: the sum of returns in each period divided by the number of periodso Geometric average: the single-per-period return that gives the same cumulative performance as the sequence of
actual returnso Dollar-weighted average: the internal rate of return of an investment
APR and EARo Annual percentage rate (APR): annualizing per-period rates using a simple interest approach, ignoring
compounding interestAPR=per−period rate × periods per yearo Effective annual rate (EAR): compounded
EAR=(1+rate per period )n−1=(1+ APRn )
n
−1
o Conversion:Typeequationhere .
Expected return: the mean value of the distribution of HPR
E (r )=∑s=1
s
p ( s )r (s)
o Scenario analysis [r(s)]: process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realized in each case
o Probability distribution [p(s)]: list of possible outcomes with associated probabilities Kurtosis: measure of the fatness of the tails of a probability distribution relative to that of a normal
distribution. Indicates likelihood of extreme outcomes Skew: measure of the asymmetry of a probability distribution
Variance:
Var (r )=σ2=¿ Standard deviation:
SD (r )=σ
Properties of investment management when returns are normally distributed:o The return on a portfolio comprising two or more assets whose returns are normally distributed also will be
normally distributedo The normal distribution is completely described by its mean and standard deviation. No other statistic is needed to
learn about the behavior of normally distributed returnso The standard deviation is the appropriate measure of risk of a portfolio of assets with normally distributed returns.
In this case, no static can improve the risk assessment conveyed by the standard deviation of a portfolio Value at risk (VaR): measure of downside risk. The worst loss that will be suffered with a given probability, often 5% Risk premium and aversion
o Risk-free rate: the rate of return that can be earned with certaintyo Risk premium: an expected return in excess of that on risk-free securitieso Excess return: rate of return in excess of the risk-free rateo Risk aversion: reluctance to accept risko Price of risk: the ratio of portfolio risk premium to variance
Sharpe (risk-to-volatility) ratio: ratio of portfolio risk premium to standard deviation
S= portfolio risk premiumstandard deviationof portfolio excess return
=E (r p )−r f
σ p
Mean-variance analysis: ranking portfolio by their Sharpe ratiosChapter 6: Diversification
Chapter 7: CAPM
Chapter 8: Efficient Market Hypothesis
Random walk: 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
securitieso Weak-form EMH: the assertion that stock prices already reflect all information contained in the history of past
trading Returns over short horizon: measuring serial correlation of stock market returns
Momentum effect: tendency of poorly performing stock and well-performing stocks in on period to continue that abnormal performance in following periods
Returns over long horizon Reversal effect: tendency of poorly performing stocks and well-performing stocks in one period
to experience reversals in the following periodo Semistrong-form EMH: the assertion that stock prices already reflect all publicly available information o Strong-form EMH: the assertion that stock prices reflect all relevant information, including inside informationo Implications:
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
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 dividends prospects,
expectations for future interest rates, and risk of the firmo Issues:
Magnitude Selection bias Lucky event
Portfolio management:o 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 such as the S&P 500
o
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