FINA%3770.007%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%March%2,%2014%%1%Reference'Sheet'Exam'2'%Five%Principles%of%Finance%1) Cash%flow%is%what%matters%2) Money%has%a%time%value%3) Risk%requires%a%reward%4) Market%prices%are%generally%right%5) Conflicts%of%interest%cause%agency%problems%%Interest%Rate%D ete rm ina nts %• Nominal'interest'rate'=%%%%%Real%risk%free%rate%%+%Inflation%risk%premium%%+%Default%Risk%premium%%+%Maturity%Premium%%+%Liquidity%Premium%%Time'Value'of'Money'Compound interest results when the interest paid on the investment during the first period is added to the principal so that during the second period the interest is earned on the original principal plus the interest earned during the first period. Holding Period Return: Holding Period $ Gain = dividend + (Priceend of period – Pricebeginning of period) Holding Period Rate of Return (%) = dividend + (Priceend of period – Pricebeginning of period) Pricebeginning of period Expected%Cash%Flow:% %%Expected%Return%Expected%Return%(%)%=%ΣPbi*ri%%Where:%%% Pi%=%probabilities%of%outcome%i%% ki%=%expected%%%return%in%outcome%I%%%FINA%3770.007%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%March%2,%2014%%2%%%Standard%Deviation%• Standard% deviation% (S.D.)% is% one% way% to% measure% risk.% It% measures% the% volatility% or% riskiness% of%portfolio%returns.%• S.D.% =% square% root% of% the% w eighted% average% squared% deviation% of% each% possible% return% from% the%expected%return.%• The% mean%(expected%value)%plu s%or%m inu s%one%standard%deviation%(σ)%covers%about%68%%of%the %area%under%the%normal%distribution%curve.%%• Standard%Deviation%is%the%square%root%of%variance,%which%is%shown%in%the%following%formula:%%%%FINA%3770.007%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%March%2,%2014%%3%%Portfolio%Risk%• The%risk%of%the%portfolio%may%be%less%than%the%risk%of%its%component%assets.%%• Total%risk%of%portfolio%is%due%to%two%types%of%risk:%%• Systematic%(or%market%risk)%is%risk%that%affects%all%firms%%(ex.:%tax%rate%changes,%war)%Also%know%as%Beta.%• Unsystematic%(or%company ^unique%risk)%is%risk%that%affects%only%a%specific%firm%(ex.:%labor%strikes,%CEO%change)%Only%unsystematic%risk%can%be%reduced%or%eliminated%through%effective%diversification.%Characteristic line is the “line of best fit” for all the stock returns relative to returns of S&P 500. • The slope of the characteristic line measures the average relationship between a stock’s returns and those of the S&P 500 Index Returns. • This slope (called beta) is a measure of the firm’s market risk Beta is the risk that remains for a company even after we have diversified our portfolio. • A stock with a Beta of 0 has no systematic risk • A stock with a Beta of 1 has systematic risk equal to the “typical” stock in the marketplace • Portfolio beta indicates the percentage change on average of the portfolio for every 1 percent change in the general market. • βportfolio = Σ wj*βj o Where wj = % invested in stock j o βi = Beta of stock j Asset allocation refers to diversifying among different kinds of asset types (such as treasury bills, corporate bonds, common stocks). • Return = Σ Weightj * Return%j Capital asset pricing model--CAPM The required rate of return for a given security can be expressed as ( )Required rate risk-free rate beta market return risk-free rate=+× −%