BU7506 – Lecture 4 – Revision Questions Solutions
FIND ANSWERS TO THESE QUESTIONS IN SLIDES FOR LECTURE 4
Give three characteristics of a market. – Price discovery q, supply/demand , Competition in the
market.
What makes a market efficient? – A market is efficient where the prices reflect all available
information
What is the characteristic of an inefficient market? – Inefficient markets where the price does not
reflect all information
What is the implication of efficient markets for returns? – It refers to the price reflects all information
and expects a normal rate of return
What is the implications of efficient markets for valuations? It refers to where the firm expect to
receive a fair value by selling securities .
Is volatility a feature of efficient markets? Why or why not?- It is volatile in the efficient markets as
the price fluctuates and can be unexpected based on the information.
What information is fully reflected in a weak form of efficient market? - prices
What information is fully reflected in a semi-strong form of efficient market?- public information
What information is fully reflected in a strong form of efficient market? – all information
What are some common misconceptions about efficient markets?- Dart throwing just as effective of
stock picking, Price fluctuations are predictable , Markets cant be efiicient only a subset of
shareholders trade.
Total risk is a function of what two sub-types of risk in financial markets? – systematic risks,
unsystematic risks
Describe systematic risk. Cannot be diversifiable, underdiversifiable, volatility risk
What are other terms for systematic risk. Market risk , undiversifiable risk , volatility risk
How is systematic risk measured? beta
List three risks that are incorporated into systematic risk. Industry risk , interest rate risk, recession,
inflation
Is it possible to mitigate against systematic risk? If so, how? No cannot be mitigated , can be mitigate
only good allocation statergies
Describe unsystematic risk. Can be diversifiable, reduces diversification
What are other terms for unsystematic risk? Unique risk. Specific risk
Is it possible to mitigate against unsystematic risk? If so, how? – yes as it reduces diversification
Give three examples of unsystematic risk.- regulation. Management changes , natural disasters
How is unsystematic risk measured or calculated? Substract systematic from total
What is “expected return” of an asset? – an individual expects a security in return
What do variance and standard deviation measure? – volatility of securities
What do covariance and correlation measure? – Relationship between two securities
What is a risk premium?- Expected return – risk free rate
What is the variance of an asset and how is it calculated? – Variance is the squares of the average
difference between expected and actual returns
What is standard deviation and what does it measure?- It is the square root of the variance.
What does it mean if a stock has low standard deviation? – It is more likely to be close to mean value
What does it mean if a stock has high standard deviation?- It is more likely to be further from mean
value.
Why is standard deviation a useful measure?- Most easily understood in similar scale returns
What is covariance and how is it calculated? – Covariance refers to average product of the deviations
What is correlation and how is it calculated? – It is standardised number between -1 and 1
What does it mean if two assets have a standard deviation of 1?- moves in similar direction
What does it mean if two assets have a standard deviation of -1?- don’t move similarly
The risk of a portfolio cannot be obtained by adding the weighted average of the risks of the portfolio
components. Why is this? What else must be taken into account?- WHY because of correlation ,
investment theory or financial markets
What is the SML?- security market line helps to plot expected returns vs beta. It shows the
relationship between systematic risk and expected returns
What is the beta of the market portfolio?- The beta is 1 because it has all assets .
What is the formula for the CAPM? RM-RF
The CAPM breaks required return of an asset into three components, what are they?- time value of
money, asset beta, market risk premium
–
What are some uses for the CAPM? Used extensively to price risk
–
Used to estimate expected returns from assets given required return
–
Used to back out cost of capital (equity) for company
–
Useful for comparison of securities
–
Used to value stocks and portfolios
What are two alternative models to the CAPM? – Arbitrage theory – multifactor model
What are the factors in the Fama-French five-factor model? – size, market risk, value, profitability ,
investments
When did Lehman Brothers collapse, sparking a banking crisis and then a debt crisis? – September
2008
Why did central banks buy assets (quantitative easing) during the global financial crisis?
What was the goal of central bank quantitative easing?
Calculation Practice
Remember to do these calculations on a calculator to replicate exam conditions!
You are given the following information about Oswald Limited and Icebreaker Incorporated.
Oswald Limited
Return in recession
Return in base case
Return in boom
Icebreaker Incorporated
5%
-10%
2%
5%
8%
14%
What is the expected return, variance and standard deviation of each stock?
What is their covariance and correlation? What does these numbers tell us about the two stocks?
Which of these stocks is most risky?
Is one of these stocks more attractive than the other from an investment perspective?
What is the cost of equity for Icebreaker if its beta is 1.7, the rate on T-bills is 2.2% and the return on
the market is estimated at 8.8%?
MCQ
1. You are discussing market efficiency with a colleague and the following statements are made.
Statement 1: Efficient markets adjust quickly to new information. Markets adjusting quickly
to new information can lead to volatility. But investors have a strong preference for efficient
markets.
Statement 2: There is a successful trader who uses technical analysis to generate substantial
returns. The technical analysis looks only at previous stock prices. Her performance is an
endorsement of the weak form of efficient market hypothesis.
Which of these statements do you agree with?
a)
b)
c)
d)
Statement 1 only
Statement 2 only
Statements 1 and 2
Neither statement
Ans B
2. With which (if any) of the following statements about risk would you agree?
Statement 1: Unsystematic risk is not compensated in the market because it can be
diversified away.
Statement 2: Examples of unsystematic risks are inflation or interest rate risks.
Statement 3: Beta is a measure of systematic risk.
a)
b)
c)
d)
Statements 2 & 3
Statements 1 & 2
Statements 1 & 3
I don’t agree with any of these statements
ANS C
3. The Capital Assets Pricing Model is a rearrangement of the Security Market Line and it
suggests that the required return on equity has three components. What are these
components?
a) The risk free rate, unsystematic risk and the return on the market minus the risk
free rate
b) Time value of money, systematic risk and the market risk premium
c) The risk free rate, beta and the return on the market
d) The market risk premium, standard deviation and stock-specific risk
ANS C
4. Which of the below is NOT a factor in the Fama-French five-factor model?
a)
b)
c)
d)
Ans D
Market risk
Size
P/B
Market risk premium