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COMPLETE Finance Study guide [4.0ed this final]

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Boston University
Information Systems
SMG IS 223

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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