Principles of Finance

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Geometric mean or arithmetic mean?
GM- long-term returns
AM- returns for a particular year
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what is unique risk?
factors affecting only one firm, this is diversifiable
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what is market risk?
economy-wide sources of risk, non-diversifiable
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what range of values must the correlation take to benefit from diversifiacation of a portfolio?
p< 1
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what is total risk made up of?
market risk (non-diversifiable) + unique risk (diversifiable)
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when is variance a good measure of risk?
when returns have approximately a normal distribution and there are no time dynamics
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what is a mean-variance efficient portfolio?
a portfolio that has the lowest risk for any given expected return
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what stops the risk-return frontier from constantly pushing to the left?
market risk
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how do you combine a risky portfolio with a riskless asset?
1. combine risky assets in to 'global' portfolio
2. combine global portfolio with risk-less asset
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what is the frontier combining the risky portfolio and risk-less asset called?
capital market line
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what are the assumptions of CAPM?
well-functioning capital amrkets
homogenous expectations
risk-averse investors
CAPM calculated with expected returns, not actual
investors can borrow and lend at the same risk-free rate
benchmark portfolio is the correct one
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what is the CAPM line also known as?
the security market line
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what's the difference between the security market line and the capital market line?
the security market line gives the expected return given a beta value
the capital market line gives the expected return for a given a variance
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when is an asset undervalued or overvalued on the SML?
undervalued when above the SML
overvalued when below the SML
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why is the cost of equity greater than the cost of debt?
debt interest expenses are tax deductible
debt is lower risk for providers:
lower variability in returns
debt covenants protect debt-holders
debt claims are prioritised in the case of bankruptcy
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why is the cost of debt lower for firms than for individuals?
interest payments are tax deductible for firms
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what two ways can you use to calculate the growth rate of dividends?
1. historical data of dividends then rearrange the constant growth model for g
2. historical data of plowback ratio and return on equity and use Gordon growth model: sustainable g = PBratio * ROE
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what are some issues with the CAPM?
validity of CAPM assumptions
stability of beta
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what are some issues of the DDM?
where do you start with historical data?
unusual years e.g. special pay-outs
negative earnings
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when is it appropriate to use the WACC as the discount rate for project appraisal?
when the funding, investing and completing of the project don't affect business risk or financial risk
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what are some assumptions for general WACC?
project is small relative to company size
reflects firms long-term capital structure and capital costs
reflects marginal cost of new capital
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what is the efficient market hypothesis?
prices reflect all available information
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what is the random walk theory?
day-to-day price movements don't reflect any pattern i.e. changes in prices of stocks are random with a slight positive trend over time
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what's the difference between random prices and the RWT?
the prices themselves aren't random, it's the successive movements in the prices that are random
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what is weak form efficiency and it's main implication?
prices reflect historical data and so patterns can't be used to predict (RWT)
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what is semi-strong from efficiency?
prices react to all public information e.g. public announcements
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what is strong form efficiency?
prices react to all public and private information
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what main two entities could have private information needed for strong-form efficiency?
corporate executives and investment funds
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why can investment funds be used as evidence for strong-form efficiency?
these funds interrogate the market for private information but on average don't produce abnormal returns which is a characteristic of an efficient market
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why can executives be used as an argument against strong form efficiency?
they have insider information and make high returns which is not a characteristic for strong form efficiency
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what are some anomalies in the EMH?
post earnings announcement drift
value investors
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why do anomalies in EMH exist?
behavioural explanations:
adopting naïve strategies
investor sentiment
bubbles
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what is meant by investor sentiment?
slow reactions to given evidence
identifying patterns in random sequences
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why would bubbles create anomalies in the EMH?
investors are only concerned with sale value and not dividend income stream
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what does risk premium depend on?
business risk
financial risk
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what makes up an investors required rate of return?
risk free rate + risk premium
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what's the traditional gearing theory?
cheap debt is introduced -> cost of equity rises due to increased financial risk and overall WACC falls due to introduction of cheaper debt
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what's M&M hypothesis?
capital structure makes no difference to the value of a firm and the value of the firm is the present values of future cash flows using ko as the discount rate
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what's the main assumption of the M&M model?
all earnings are paid out as interest and dividends
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what are the assumptions for no tax M&M?
-no transaction costs
-rational investors taking advantage of arbitrage
-investors can borrow unlimited amounts of money at the same risk-free rate as the firm
-no tax
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what are the criticisms of no tax M&M?
-inefficiencies hamper arbitrage
-doesn't account for transaction costs
-taxes exist
-cost of debt increases at high gearing
-personal and corporate borrowing aren't perfect substitutes
-rational shareholders have perfect info
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what advantage do geared firms have over ungeared in the with tax M&M?
tax deductions from interest payments
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what are some costs of financial distress?
-more debt -> higher default risk
-bankruptcy costs, direct and indirect
-costs from distorted decisions before bankruptcy
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what is the trade-off theory?
capital structure is based off trade-off between tax savings and distress costs
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how do you calculate the WACC for a geared firm using an identical ungeared firm?
1. de-gear surrogate firm
2. re-gear to capital structure of actual firm
3. calculate CAPM using new beta
4. use CAPM in WACC calcualtion
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why isn't WACC appropriate as a discount rate for geared firms
WACC is dependent on cost of equity -> cost of equity is dependent on positive NPV projects
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when can WACC be used as a discount rate?
when a firm is all equity financed or using no tax M&M
project must not effect financial risk
unaffected financial risk includes sticking to target gearing ratio or any change to gearing being temporary
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when should the adjusted present value model be used over WACC?
when a project will effect the firms operating and financial risk
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what is the flow of funds constraint?
any increase in dividends must be financed by either issuing new shares or cutting back on investments
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what is the 'homemade' dividend argument?
if investors want cash now they'll sell some of their investment
if investors need cash for the future, they'll reinvest their dividends
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what are some stylised dividend facts
-managers are reluctant to make dividend changes if they'll need to be reversed in the future
-firms have long-term target dividends pay-out ratios based on sustainable earnings
-managers smooth dividends to avoid risk of reduction in pay-out
-changes in
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what is traditional dividend theory?
-shareholders aren't necessarily indifferent since share prices change with dividends
-homemade dividends involves transaction costs
-agency issues
-dividends seen as marginal signal of performance
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why might derivatives stabilise or destabilise financial markets?
firms use derivatives to hedge (stabilise), other entities use derivatives to speculate (destabilise)
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what's an option?
a contract that gives the holder the right to buy or sell a security at a given price on a specified date
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what are futures and forwards contracts?
contracts for the delivery of a security on a specified date at a specified time
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what's the difference between a future and a forward?
a forward is a customisable contract between two entities whereas futures are standardised contracts traded by an entity on an exchange
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what is marking-to-market and what does it do?
reduces the counterparty risk by settling gains and losses daily until the date of maturity
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what is an initial margin?
an amount of money paid by both parties held in an intermediate bank to be paid to the counterparty in case of default
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what's a maintenance margin?
an additional amount of money paid by a party to the intermediate bank as the prices moves against them
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what are the types of yield for stocks, commodities and forex, respectively?
stocks is a cash yield
commodities is a manufacturing or sales convenience
forex is the interest payments in a different currency
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which is the base and which is the price (domestic) currency? EUR:GBP
EUR is base
GBP is price (domestic)
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what is a direct currency quote and what is an indirect currency quote?
a direct quote is the rate given with the base currency as 1, an indirect quote is the rate given witht he price currency as one
e.g. USD is base, GBP is price
direct: $1 : £x.**
indirect: £1 : $y.yy
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when is the forward margin at a premium or a discount?
premium when the futures foreign currency is worth less than the spot rate
discount when the futures foreign is worth more than the spot rate
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how would you make a synthetic forward rate?
1. borrow amount (B = current rate/(1+foreign r/i)) in domestic currency at domestic interest rate
2. exchange this amount and deposit at foreign rate for a year
3. collect interest in a year and exchange back at spot rate
4. pay back interest in domestic
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why are arbitrage opportunities not possible in reality?
dealer have bid-ask spread
prices and quotes adjust to non-arbitrage
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what are the first 4 steps for hedging with a futures contract?
1. identify forex transaction to do e.g. £ in to $
2. decide how many contracts to buy (to nearest whole number)
3. decide on date (first after date of transaction)
4. identify underlying currency i.e. currency coming in
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what are the last 3 steps for hedging with a futures contract?
5. express the forex in terms of incoming currency i.e. selling underlying currency
6. set up the hedge
7. unwind hedge and convert at spot rate
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what are some natural hedging methods?
matching currency of foreign assets and liabilities e.g. UK company having German subsidiary
matching foreign sales with foreign costs e.g. Nissan in UK
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what can the premium of an option be decomposed in to?
intrinsic value + time premium
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should an investor still execute a call option when stock price is greater than exercise price if they're making a loss?
yes, because it's still minimising losses
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what is put-call parity?
each security can be created from others
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what is a long straddle?
buying a call and put take advantage of an expected event e.g. earnings announcement by making profit if the stock falls or rises by a certain amount
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what is the effect of the underlying stock price, on a call's premium?
higher the stock price, higher the premium (bigger difference from exercise price)
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what is the effect of strike price, on a call's premium?
higher the strike price, lower the premium (less likely it'll occur)
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what is the effect of volatility of a stock, on a call's premium?
higher the volatility, higher the premium (protected from downside risk by not buying)
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what is the effect of time to expiration, on a call's premium?
more time to expire, higher the price (more time for price to go up)
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what is the effect of risk-free rate, on a call's premium?
higher the risk-free rate, higher the premium
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what are some pitfalls of IRR?
-multiple rates of return
-can't compare mutually exclusive projects because it ignores magnitude
-can't tell if lending or borrowing is the better option
-possible to have no IRR
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why should the equivalent annual costs be used over NPV when appraising mutually exclusive investments
MPV can mislead when projects have different economic lives
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how do you calculate equivalent annual costs?
present vale of costs / annuity or perpetuity factor
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what's a pure discount bond?
one that has no coupon payments, just a face value payment at maturity
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how can re-investments affect stock price?
if firms pay lower dividends in order to re-invest then stock price could increase due to higher possible future dividends
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what is the present value of growth opportunities?
the net present value of the investments the firm is expected to make in the future
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Card 2

Front

what is unique risk?

Back

factors affecting only one firm, this is diversifiable

Card 3

Front

what is market risk?

Back

Preview of the front of card 3

Card 4

Front

what range of values must the correlation take to benefit from diversifiacation of a portfolio?

Back

Preview of the front of card 4

Card 5

Front

what is total risk made up of?

Back

Preview of the front of card 5
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