FINS1612 Lecture Notes - Lecture 4: Market Capitalization, Systematic Risk, Price Discovery

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18 May 2018

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Friday, 31 March 2017

Capital Markets & Institution

Equity Markets II

-Investors buy shares to receive returns from dividends & capital gains (can be losses)

-Factors encouraging investment in securities quoted on stock exchange:

•Depth of market - market capitalisation

•Liquidity of market - volume of trading relative to size of market

•Efﬁcient price discovery - speed & efﬁciency with which new information is reﬂected

in current share price (ie continuous reporting)

-Systematic Risk: Exposures that affect the price of the majority of shares listed on a

stock exchange (e.g. interest rates, exchange rates, economic growth)

-Unsystematic Risk: Exposures that speciﬁcally impact on the share price of a

particular corporation

•e.g. resignation of CEO, performance forecasts, technology failure, dissent within

board of directors

-Diversiﬁed Investment Portfolio: (10-25 stocks)

•Investment portfolio that includes a wide range of ﬁnancial securities & assets

•Diversiﬁes away unsystematic risk exposure of individual securities

-Investors don’t receive higher returns for unnecessarily bearing unsystematic risk

•Remaining risk is systematic risk - measured by beta (average beta = 1.0)

-Statistical measure of the sensitivity of an asset price relative to the market

•Systematic risk of investment portfolio is given by the weighted average of the beta

of individual shares

•Expected portfolio return - weighted average of expected returns of each share held

•Portfolio variance (risk) - variability of returns of an investment portfolio over time

-Result of variance of each individual investment contained within portfolio & the

co-variance or correlation between pairs of securities

-Co-variance/ correlation - measures how two share prices move relative to each

other; either positive (same direction) or negative (opposite directions)

•Two approaches to investment:

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Friday, 31 March 2017

-Active investment approach - portfolio structure based on share analysis, new

information & risk/return preferences (fundamental & technical analysis)

-Passive investment approach - portfolio structure based on replication of a

speciﬁc share-market index (ASX 200) or sector index (telecommunications)

-Some managed funds are index funds - acquire shares so that portfolio fully or

partially replicates a speciﬁc share-market index

•Considerations:

-Risk vs return (systematic & unsystematic risk, beta & diversiﬁcation)

-Investment time horizon - portfolios on average, earn higher returns over longer

investment time horizon of 5 years or more

-Income vs capital growth - different liquidity needs (preference of regular

dividends or price increases; capital gains)

-Domestic & international share investments - diversiﬁed share portfolio typically

includes stocks from home markets & selection of international share markets

•Strategic asset allocation - portfolio structured to meet investor’s personal

preferences (cash-ﬂow requirements, tax position, risk tolerance etc)

•Tactical asset allocation - portfolio structured to take account of dynamic investment

environment

-Buying & Selling Shares:

•Considerations:

-Liquidity - how easily shares can be converted to cash (sold)

-Risk - including variance, standard deviation, beta, volatility

-Integrity - of company, management & share market

-Charges - transaction costs (fees on managed funds, brokerage on direct

transactions through stockbroker

-Return - type of expected return (dividends, capital growth)

-Capital growth - factors affecting level of growth (inﬂation, interest rates,

economic & business cycles)

-Accessibility - depth & liquidity of primary & secondary markets

-Flexibility - portfolio restructuring, active investment, passive investment

-Taxation - income tax, capital gains tax, dividend imputation (if available)

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Friday, 31 March 2017

-Social security - effect of investment on income test & assets test associated with

social security beneﬁts (if applicable)

•Direct investment - investor buys & sells shares directly through a stockbroker

•Stockbroker - acts as agent for a investor in buying & selling of stock-market

securities

-Discount broker executes buy & sell orders for clients; no investment advice or

services

-Full-service advisory broker executes buy & sell orders but also provides other

services to clients, including investment advice

•Indirect investment - investing through a funds manager in a unit trust or managed

fund (e.g. equity trusts)

-Fees may include entry, exit, administration costs & are usually higher than direct

investment fees

-Taxation:

•Marginal rate of tax - percentage of income tax paid progressively increases relative

to the amount of income earned

•Pre-dividend imputation (prior to 1987) - dividends taxed twice

-At company level (as proﬁts) then at investor’s marginal rate

•Dividend imputation (since 1987) - removed double taxation of dividends

-Investors receive franking credit for tax a company pays on a franked dividend

•Capital gains tax on shares:

-Tax free prior to 19/9/85

-19/9/85 - 21/9/99

•Taxpayer’s marginal tax rate applied if held less than 12 months

•Taxpayer’s marginal tax rate applied to indexed capital gain if held over 12

months

-Since 21/9/99

•50% discounted gain if held at least 12 months

•Indexed capital gain or 50% discounted gain if purchased between 19/9/85 &

21/9/99

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Document Summary

Investors buy shares to receive returns from dividends & capital gains (can be losses) Systematic risk: exposures that affect the price of the majority of shares listed on a stock exchange (e. g. interest rates, exchange rates, economic growth) Unsystematic risk: exposures that speci cally impact on the share price of a particular corporation: e. g. resignation of ceo, performance forecasts, technology failure, dissent within board of directors. Diversi ed investment portfolio: (10-25 stocks: investment portfolio that includes a wide range of nancial securities & assets, diversi es away unsystematic risk exposure of individual securities. Investors don"t receive higher returns for unnecessarily bearing unsystematic risk: remaining risk is systematic risk - measured by beta (average beta = 1. 0) Result of variance of each individual investment contained within portfolio & the co-variance or correlation between pairs of securities. Co-variance/ correlation - measures how two share prices move relative to each other; either positive (same direction) or negative (opposite directions: two approaches to investment:

Related Questions

Question 18

1. Which of the following does an efficient portfolio do?

1. Maximizes risk for a given return.

2. Minimizes risk for a given return.

3. Maximizes return for a given level of risk.

4. Minimizes return for a given level of risk.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 19

1. The security market line does not:

	a.	Indicate the relationship between risk and return.
	b.	Relate the market return and beta to a stock's return.
	c.	Identify the optimal portfolio for the investor.
	d.	Use beta coefficients as a measure of risk.

3 points

Question 20

1. Mutual funds ____ realized capital gains and income (for example, dividends received):

	a.	Retain.
	b.	Reinvest.
	c.	Distribute.
	d.	Distribute or reinvest.

2 points

Question 21

1. An index fund limits its portfolio to:

	a.	High quality securities.
	b.	Stocks that respond to changes in the consumer price index.
	c.	Stocks included in an aggregate measure of stock prices.
	d.	Stocks of firms in a particular industry.

2 points

Question 22

1. Mutual funds with beta coefficients greater than 1.0:

	a.	Have outperformed the market.
	b.	Have underperformed the market.
	c.	Have more systematic risk than the market.
	d.	Have less systematic risk than the market.

3 points

Question 23

1. Which of the following will tend to cause a stock's price to fall?

1. The firms beta declines.

2. The firms beta increases.

3. The risk-free rate declines.

4. The risk-free rate increases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

2 points

Question 24

1. The use of P/E ratios to select stocks suggests that:

	a.	High P/E stocks should be purchased.
	b.	Low P/E ratio stocks are overvalued.
	c.	A stock should be purchased if it is selling near its historic low P/E.
	d.	A stock should be purchased if it is selling near its historic high P/E.

2 points

Question 25

1. What does the efficient market hypothesis require?

1. Financial markets to be competitive.

2. Prices to adjust rapidly.

3. Prices of undervalued securities to fall.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 26

1. Which of the following does the strong form of the efficient market hypothesis suggest?

1. Inside information will not lead to superior investment results.

2. Inside information will lead to superior investment results.

3. Studying financial statements will not lead to superior investment results.

4. Studying financial statements will lead to superior investment results.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 27

1. Which of the following is the least broad-based measure of stock prices?

	a.	NASDAQ market index.
	b.	Dow Jones industrial average.
	c.	S&P 500 stock index.
	d.	AMEX market value index.

3 points

Question 28

1. What is dollar-cost averaging?

	a.	Periodically buying a round lot of stock.
	b.	Periodically investing a specified dollar amount in a stock.
	c.	A means to increase the average cost basis.
	d.	A means to ensure a positive return.

2 points

Question 29

1. Stock dividends cause:

	a.	The price of a share of stock to rise.
	b.	The price of a share of stock to fall.
	c.	The value of the firm to rise.
	d.	The value of the firm to fall.

2 points

Question 30

1. Which of the following occurs when a stock has a two-for-one split?

	a.	The price of the stock doubles.
	b.	The firm's assets increase.
	c.	The firm's liabilities decrease.
	d.	The par value of the stock is reduced.

3 points

Question 31

1. Dividend reinvestment plans offer which of the following advantages?

1. Deferment of federal income taxes.

2. A convenient means to accumulate shares.

3. Dollar-cost averaging.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	2.

3 points

Question 32

1. When the Federal Reserve seeks to expand the money supply, it:

	a.	Sells securities.
	b.	Buy securities.
	c.	Runs a deficit.
	d.	Runs a surplus.

2 points

Question 33

1. The sum of cash, currency, and demand deposits is:

	a.	M1.
	b.	M2.
	c.	M3.
	d.	M4.

3 points

Question 34

1. If the Federal Reserve lowers the target federal funds rate:

	a.	The discount rate rises.
	b.	Liquidity in the banking system is increased.
	c.	Security prices fall.
	d.	Required reserves are also decreased.

3 points

Question 35

1. The anticipation of inflation suggests that the investor should:

	a.	Buy bonds.
	b.	Anticipate higher interest rates.
	c.	Avoid real estate investments.
	d.	Sell stocks of gold companies.

3 points

Question 36

1. The current ratio is unaffected by:

	a.	Using cash to pay a dividend.
	b.	The collection of an account receivable.
	c.	Selling inventory for a profit.
	d.	Selling bonds and using the funds to finance inventory.

2 points

Question 37

1. Which of the following are true as the debt ratio increases?

1. Fewer assets are debt financed.

2. More assets are debt financed.

3. The ratio of debt equity increases.

4. The ratio of debt equity decreases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

2 points

Question 38

1. The technical approach suggests that future stock prices are forecasted by:

	a.	Past stock rates.
	b.	Financial ratios.
	c.	Accounting statements.
	d.	Monetary policy.

2 points

Question 39

1. The Dogs of the Dow strategy:

	a.	Forecasts the direction of the Dow Jones averages.
	b.	Suggests buying the Dow stocks with the highest dividend yields.
	c.	Outperforms the S&P 500.
	d.	Suggests buying the lowest-priced Dow stocks.

3 points

Question 40

1. Behavioral finance combines aspects from which two fields in an attempt to identify human traits that affect investment decisions?

	a.	Accounting and finance.
	b.	Finance and psychology.
	c.	Physics and finance.
	d.	Finance and marketing.

ultramarineguinea-pig196

1ï¼

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. There is no corporate tax.

Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in with stock. The number of shares of Without stock you purchased is closest to:

A425 B1650 C2000 D825

2ï¼

Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. There is no tax.

Galt's asset beta (ie the beta of its operating assets) is closest to:

A1.1 B1.2 C1.3 D1.4

3ï¼

Taggart Transcontinental has a value of $500 million if it continues to operate, but has outstanding debt of $600 million. If Taggart declares bankruptcy, bankruptcy costs will equal $50 million, and the remaining $450 million will go to creditors. Instead of declaring bankruptcy, Taggart proposes to exchange the firm's debt for a fraction of its equity in a workout. The minimum fraction of the firm's equity that Taggart would need to offer to its creditors for the workout to be successful is closest to:

A50% B75% C83% D90%

Can you tell me What does this article tell us about the bond markets performance and the interest rate environment?

Long-Term Government Bonds Shine as Fed Goes Slow

Pimco, Vanguard funds with focus on long-term debt beat out other bond funds in the 1st quarter

For investors, one of the best bets of 2016 has been a wager via U.S. Treasurys on falling interest rates.

A Pimco long-term government-bond fund was the best performer among bond funds in the first quarter. Above, Pimco offices in Newport Beach, Calif. PHOTO: MIKE BLAKE/REUTERS

The $460 million Pimco Extended Duration Fund posted a total return of 11.8% in the first quarter, making it the best performer among 2,015 U.S.-based bond mutual funds, according to data from Morningstar. Total return reflects price gains plus periodic payments.

The runner-up was $1.3 billion Vanguard Extended Duration Treasury Index Fund, which returned 11.7% during the quarter, according to Morningstar.

Both funds posted their best returns since the last quarter of 2014 and have extended those gains in the early days of the second quarter. Duration refers to a fundâs exposure to interest-rate risk, meaning its prices will rise more when rates fall and fall more when rates rise.

Analysts have warned repeatedly that bets on duration are risky, given the long decline in interest rates over recent years. The gains are striking at a time when stocks and other riskier assets have rebounded from an early-year selloff that at one point left the Dow industrials down 10%. The Dow fell 20.55 points, or 0.1%, on Monday, but is up 0.8% for the year.

While safer securities such as U.S. Treasurys and German bunds tend to decline in price when stocks and low-rated corporate bonds rally, many analysts say the simultaneous rise of safer and riskier assets this spring is tied to the unexpectedly slow pace of policy tightening by the Federal Reserve, along with signs the global economy continues its slow healing.

FINS1612 Lecture Notes - Lecture 4: Market Capitalization, Systematic Risk, Price Discovery

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