Chapter 5:

Risk is determined by:

1. the uncertainty on future cash flows and

2. this uncertainty is the result of factors peculiar to each asset.

- Higher the risk, higher the return.

Holding Period of Return (HPR): the percent your investment earned during the
time you held it.

Random Variables: Objects that have more than one possible outcome and which
the magnitude of the outcomes is uncertain beforehand. These outcomes are called
states of nature.

Ex. The states of nature for tomorrow’s weather are rain, sun, clouds and etc.

Risk requires both harm and uncertainty.

Standard Deviation: measure of risk of a single asset. Greater the standard deviation,
the greater the risk.

Portfolio: A collection or group of assets held as an investment.

Chapter 6:

Nondiversifiable risk (market or systematic risk): Events that affect all assets to
some extent. Eg. Wars, recession…

Diversifiable risk (firm-specific or unsystematic risk): Events that only affect one
firm or few firms. Eg. Strikes, loss of major customer…

Total Risk = Nondiversifiable risk + Diversifiable risk

Naïve Diversification: maximize return, minimize risk

- market portfolio is value weighted; the weights are the relative values of
each asset in the portfolio
- all investors should optimally hold a portfolio with the same assets in the
same proportions (and will earn the same return)
- the market portfolio is the aggregation of the individual investor portfolios
CAPM – Capital Asset Pricing Model

- investors who hold the market portfolio do not care about unsystematic risk.
- The CAPM yields a measure of systematic risk called beta and an equilibrium
relationship between beta and expected returns

All investors hold the market portfolio.

Marginal Risk: is equal to the covariance between the returns on the asset and the
market portfolio.

Beta: is the measure of risk for large portfolio holders. Beta also measures the
amount of market (systematic) risk possessed by an individual asset.

Characteristics Line: The slope of the characteristics line is the beta of the security.

The market’s beta is equal to 1!

The risk-free asset’s beta is equal to 0!

Portfolio-possibility lines: the graph of the set of risks and returns produced by
those portfolios

Treynor Index: the slop of the portfolio-possibility lines. We use the treynor index to
derive an equilibrium relationship between risk and return.

Buying on margin: borrowing to buy more than you can afford with your own
money. Assumption: we borrow by issuing T-bills so the cost of the borrowing is the
risk-free rate

Treynor Index: measure the excess of the asset’s return over the risk-free return per
unit of its systematic risk. This excess return is also called the risk premium.

- In equilibrium, all securities has the same Treynor Index

If a stock lies below the SML, then it is overvalued.

Chapter 8:

Shares (Stocks) are securities issued by incorporated companies. Shares

represent equity or ownership in a company.

To make the price of a preferred share change, you would need to make the
dividend or required return (k) change.
Required Return: what we need to earn to be satisfied for the risk of owning the
security.

Expected Return: what we project will actually be generated by the security.

Only if the expected return exceeds the required return will we buy.

For companies where dividends grow at a non-constant rate, we value the shares
using a three-step method:

1. Determine the dividend expected at the end of each year during the non-
constant growth period.
2. Estimate the constant growth rate and use it to price the dividend stream
that begins after the non-constant growth period.
3. Find the present value of the… (8.3.16)

Chapter 19:

Futures and options are derivative contracts.

Price Risk: The risk that the price (or value) of an asset/security will move
adversely in the future.

Hedge: Actions that reduce price risk.

Speculating: Action that increases price risk. Speculators accept price risk in the
hope of making a profit.

Spot Contract: An agreement between buyer and selling to exchange a commodity

immediately. The agreed upon price is called the spot price.

Forward Contract: A modification of a spot contract where the price, quantity and
quality of the goods exchanged are agreed on at initiation, but the actual exchange of
goods for money occurs at a later date. Privately negotiated.

In North America, the first organized futures exchange was the Chicago Board of
Trade. (CBOT)

Futures Contract: An institutionalized version of a forward contract. Futures differ

from forwards in that they are standardized, traded on exchange, feature a
clearinghouse and involve margin and daily resettlement.

• Futures Contracts are traded on exchange and the terms of the contract are
not privately negotiated. The only element negotiated by the counterparties
is the price.
Marking to Market (Daily Resettlement): The process where clearinghouses track
the details of each trade and calculate the daily profit and losses. Brokers then debit
and credit their client’s accounts.

Offset (reversing) trade: When you have purchased a contract and are the “buyer”,
but before the maturity date, you sell it and become the “seller”. Afterwards, the
clearinghouse ignores you and you have no delivery obligations.

The differences between Forwards and Future Contracts:

1. Forward contracts are customized. Futures are standardized.

2. Forwards are traded in a dealer (over-the-counter) market. Futures are
exchange traded.
3. Forwards can only be completed by making or taking delivery. Futures can
also be completed through an offset reversing trade.
4. Forwards are settled on the maturity date. Futures have daily marking-to-
market.

Options are contracts between two counterparties. There are two types of options:
Calls and Puts.

The owner of a call option pays a premium and has a choice to buy an underlying
asset before a specified date at an agreed upon price (strike price).

The owner of a put option pays a premium and has the right to sell an underlying
asset at an agreed upon price (strike price) before a specified date.

Options:

1. They are contracts, like futures, and not securities.

2. There are two cash flows: the premium and the strike price.
3. Buyers, not sellers, have the option.
4. Buyers pay the premium for the option and sellers receive it.

Wants price to RISE Wants Price to FALL.

Wants Price to FALL. Wants Price to RISE.

The premium of the option contact is the price that is negotiated between the buyer
and seller. All other elements of the contract – strike price, expiration, quantity, and
quality of the underlying asset – are fixed by the exchange.

Two varieties of options: American and European.

American can be exercised at any time prior to expiration.

European can only be exercised at expiration.

Intrinsic Value: Payoff value.

Moneyness:

In the money: positive intrinsic value.

Out of the money: intrinsic value of zero.

At the money: Share price equals strike price.

If an option premium is less than the intrinsic value (payoff), there exists an
arbitrage opportunity.

Time value = option premium – intrinsic value

The main factors that affect time value are:

1. time
2. volatility

Chapter 2.3:

Cross-Sectional Analysis: Comparing ratios between multiple companies.

Time-Series Analysis: Comparing a firm’s current performance to prior periods.

Ratios:

1. Profitability
2. Liquidity
3. Activity
4. Financing
5. Market

Profitability: measures how effectively the firm uses its resources to generate
income. Ultimately, the most important ratio.

Liquidity: It is not necessarily bad for firm’s to have low current and quick ratios if
the firm is able to meet its obligations.

Activity Ratio: measures the efficiency with which assets are converted to sales or
cash. Generally, greater activity is good.

Financing: measures how leverage a firm is. A firm’s risk is closely tied to the firm’s
leverage.

Market Ratio: they are based on information not contained in the firm’s financial
statements.
Common-Sized Financial Statements: Dividing all balance sheet lines by total assets
and dividing all income statement lines by sales.

A firm can change its ROE by adjusting any one of the 3 components:

• it can have high turnover of its product

• it can have large margins on each sale

• it can be highly leveraged.

The financial analysis of a firm should include the following steps:

1. Analyze the economy in which the firm operates

2. Analyze the industry in which the firm operates
3. Analyze the competitors that currently challenge the firm
4. Analyze the strengths and weaknesses of the firm, using common-sized
statements and ratios

Chapter 14.1 & 14.3:

Sales Forecast:

Sales = P X Q

Where Q = IQ X Market Share of the firm

Sales Forecast for Retailers:

Sales = #Stores x Area x $Sales per square foot