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Final

# COMPLETE Finance Study guide [4.0ed this final]

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Boston University

Information Systems

SMG IS 223

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Chapter 12 Some Lessons From Capital Market History
Returns: gain/loss from investment
-income component: cash received directly from investment
-capital gain/loss: change in value of assets from when one buys investment to one sells
-capital gains should be included in the cash flow
-Total Dollar Return = income + capital gain/loss
-Percentage Returns = dividend yield + capital gains yield
-dividend yield = dividend paid during the year / price of stock at beg. of year
-capital gains = (priceend– pricebeg/ price beg
-Average Returns
-nominal averages: simply averages all the numbers does not count for inflation
-arithmetic average return: returned earned in an average year over a multiyear period (what one
earned in a
typical year)
-geometric average return: average compound return earned per year over a multiyear period (what
someone
actually earns)
(1/t)
-GAR = [(1+r )11+r )2(1+r)] t – 1
-When predicting future forecasts
-use arithmetic average return IF one knows the exact AAR
-if one only knows estimates, use Blume’s Formula:
[(T-1)/(N-1)] * (geometric average) * [(N-T)/(N-1)] * arithmetic average
where N = # years of data
T = how many desired years average
-risk premiums: excess return required from an investment in a risky asset over that required from a
risk-free asset
Variability of Returns
-frequency distribution: chart of distribution
-variance: average squared difference between the actual return and the average return
-standard deviation: positive square root of the variance
-normal distribution: bell-shaped frequency distribution that’s defined by mean and standard deviation
-On average, bearing risk is handsomely rewarded
Capital Marketing Efficiency
-market values of stocks/bonds can fluctuate widely from year to year
-efficient capital market: security prices reflect available information (no need to question
appropriateness)
-weak form: at very least a stock’s past prices are reflected (no need to study past patterns)
-semi-strong form: all PUBLIC info is reflected in stock price
-strong form: all info of every kind is incorporated in stock price (no such thing as inside info)
-efficient market hypothesis: actual capital markets, such as the NYSE, are efficient
-all investments in market are ZERO NPV investments Chapter 13 Return, Risk, And the Security Market Line
Expected Returns: the return on a risky asset expected in the future (weighted against probability of future
economy)
Projected Risk Premium = Expected Return – Risk free rate
Variance = Sum ([return deviation from expected return ] [pro1ability ] +… 1 [RDER ] [p ]) N 2 N
1/2
Standard Deviation = variance
Portfolios: a group of assets such as stocks and bonds held by an investor
-portfolio weights: % of a portfolio’s total value that is in a particular asset
ex) StockN = 150 Stock = $120 Portfolio = $200
Weight 1 50/200 = .25
Weight 2 150/200 = .75
-expected portfolio returns = [(probability of economy state)(portfolio weight )+ (1 )(we2ght )] 2
-portfolio variance = ?
-combining assets into portfolios can substantially alter the risks faced by the investor
Total Return = Expected Return + Unexpected Return
-where expected return is predicted based on data; unexpected return is risk associated with unknown
data
-announcement = expected part + surprise
-announcements can affect returns if announcement is NEW INFORMATION
-“discount” means news is already been considered
Systematic and Unsystematic Risk
-systematic risk: influences a large number of assets (market risk)
-unsystematic risk: affects at most a small number of assets (asset-specific risk)
-Thus,
Total Return = Expected Return + Systematic risk + Unsystematic Risk
Diversification and Portfolio Risk
-standard deviation decreases as # of securities increases
-principle of diversification: spreading and investment across a # of assets will eliminate some, but
not all, risk
-non diversifiable risk: min. level of risk that cannot be eliminated simply by diversifying
-unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets
has almost
no unsystematic risk (diversifiable risk ~ unsystematic risk)
-systematic risk is non-diversifiable
Systematic Risk and Beta
-systematic risk principle: expected return on a risky asset depends only on that asset’s systematic
risk
-beta: amount of systematic risk present in a particular risky asset relative to that in an average risky
asset
(ex. 0.50 = half as risky, 2 = twice as risky)
-portfolio’s beta = (asset 1s beta)(weight)+ (asset ’s2beta)(weight)
The Security Market Line
-a risk free asset has beta = 0 -% invested in asset can exceed 100%
-“risk to reward” ratio = slope
-the risk to reward ratio must be the same for all assets in the market
-security market line: positively shaped straight line showing the relationship between expected return
& beta
-market risk premium: slope of SML – difference between the expec

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