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Finance Study Notes: Competitive Markets, Risk, and Options

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Chapter 3
3.1
Competitive Markets:
●​ A good can be bought at the same price it is sold.
●​ Allow us to calculate the value of a decision without worrying about the tastes or
opinions of the decision maker
●​ Can be used to determine cash value and evaluate decisions in most situations
Costs and benefits:
●​ Always the first step in evaluating a project.
Chapter 10
10.1
Risk and return:
●​ The higher average return compensates for the greater risk investors are taking.
●​ Canadian treasury bills offered the lowest overall return over the past fifty years.
●​ S&P 500 provides the highest average annual return
●​ Barrick gold corp provides the highest variations in annual return
●​ The average capitalization of firms in the S&P 500 is about 9.2 billion
10.2
Common Measures of risk and return
●​ Variance increases with magnitude of deviations from the mean
●​ If return is riskless and never deviates from its mean the variance = 1
●​ Return indicates the percentage increase in the value of an investment per dollar initially
invested in the security.
●​ Variance is not easier to interpret than standard deviation
10.3
Realized return: The return that actually occurs over a particular time period (Historical) =
(1+R1)(1+R2)(1+R3)...... - 1
Expected return: The return that we expect over a period of time
Dividends: Common practice to assume that all dividends are reinvested and used to purchase
additional shares of the same stock.
Standard Error: Provides an indication of how far the sample average might deviate from the
expected return.
95% confidence interval for expected return = Historical average return +- two standard errors.
The geometric average return:
●​ Used for comparative purposes
●​ Will always be below the arithmetic average return, difference grows with volatility of
annual returns.
●​ Better description of long-run historical performance of an investment.
The arithmetic average return:
●​ Should use this when trying to estimate an investment's expected return over a future
horizon based on its past performance.
Dividend Yield: Div/P0
Cap gains rate/yield: P1 - P0/P0
For historical returns:
Average annual return: (Realized returns + 1) - 1 / N
Average variance:Sum of (R - Average Annual returns)2 / N -1
SD = Root of average variance
SE = SD/ root N
95% confidence interval = Average annual return +- 2 x SE
10.4
Volatility
●​ Volatility is not a reasonable measure of risk when evaluating returns on large portfolios
and the returns of individual securities.
●​ Historical average annual return has a positive relationship with volatility.
●​ It is false to say that smaller stocks have lower volatility than larger stocks.
●​ Expected returns for individual stocks do not increase proportionately with volatility, but
there is a relationship between them when it comes to large portfolios.
Excess return
●​ The difference between the average return on a security and the average return for
treasury bills.
10.5
Common risk
●​ Also called correlated risk, or undiversifiable risk, systematic (systematic risk does
impact risk premium), market risk
Independent risk
●​ Also called uncorrelated risk, or idiosyncratic risk (idiosyncratic risk does not impact risk
premium), not systematic.
●​ This risk is diversifiable
10.6
●​ It is only those risks that cant be eliminated by holding a large portfolio that determine
the risk premium required by investors
●​ Things that are more economical are less diversifiable
10.7
Measuring systematic risk
●​ The key to measuring systematic risk is finding a portfolio that contains only systematic
risk
●​ The beta is the expected percent change in the excess return of a market security for a
1% change in the excess return of the market portfolio. Measures sensitivity of a security
to market wide risk factors. Only systematic risk.
●​ The portfolio that contains all shares of all stocks and securities in the market is called
the market portfolio
●​ If we assume that the market portfolio is efficient, then changes in the value of the
market portfolio represent systematic shocks to the economy.
●​ An efficient portfolio is one that contains only systematic risk.
●​ Cost of capital & Beta are related to the systematic risk
Chapter 11
11.1
Chapter 13
Chapter 14
Straddle - Holding a long position in both a put and a call option with the same strike price
Strangle - Holding a long position in both a put and call with a strike price of the call being
higher than the put by a bit, if it goes outside of the strike price we make money.
Law of one price - The stock and a put, or a bond and a call must have the same price.
14.4
●​ The time value of an option is the difference between the current option price and its
intrinsic value
●​ When volatility goes up, the value of options go up as well.
●​ A european option can be worth less than an american option
●​ An american option cannot be worth less than its intrinsic value, therefore cannot have a
negative time value
●​ Maximum value of an option is its strike price
14.5
●​ The price of any call option on a non-dividend paying stock is always greater than its
intrinsic value, therefore it's never optimal to exercise early.
●​ The price of an option is more sensitive to changes in volatility for at the money options
than it is for in the money options.
14.6
●​ When a firm's assets are worth less than the required debt payment, the put is in the
money, the owner of the put option will therefore exercise the option and receive the
difference between the required debt payment and the firm's asset value.
●​ A share of a stock can be thought of as a call option on the assets of the firm with a
strike price equal to the value of debt outstanding
Chapter 16
16.1
●​ Real options allow a decision maker to choose the most attractive alternative after new
information has been learned, the presence of real options adds value to an investment
opportunity
●​ To make an investment decision correctly, the value of embedded real options must be
included in the decision making process
●​ A key distinction between a real option and a financial option is that real options are not
traded in competitive markets
●​ We can compute the value of the real option by comparing the expected profit without
the real option to the value with the option.
Chapter 23
23.1
Angel investors:
●​ For many start ups, the first round of outside private equity financing is obtained from
them
●​ Typically friends or acquaintances of the entrepreneur
●​ Crowdfunding has NOT precluded the need for large amounts of angel finding for start
up firms
Venture capitalists:
●​ Can provide substantial capital for young companies
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