7:Capital Asset Pricing Model (CAPM): Systematic & Non-Systematic Risk: mkt.

risk is the only relevant risk for the well-diversified investor; only mkt risk is rewarded. Beta: measure of mkt risk. Beta of a Portfolio: Weighted Avg. of individual security betas. Alpha (if CAPM holds, alpha=0): measure of performance on a risk-adjusted basis. Abnormal rate of return on a security/port in excess of what would be predicted by CAPM. Market Risk Premium: Security Market Line (SML): Rolls Critique: can never prove/disprove CAPM bc true mkt portfolio is unobservable. Single Factor Model (eg. CAPM) vs Multi-Factor Model (Fama & French): Fama & French 3 Factor Model: Market, Size, BV/MV (need 3 betas & forecast for each factor) ^Ret=related to factors other than mkt returns; Size (SMB=Small Minus Big); BV relative to mkt val (HML=High Minus Low); 3 Factor Model better describe returns. Arbitrage Pricing Theory (APT): arises if investor can construct a 0 beta investment portfolio w/ return greater than the risk-free rate; if 2 portfolios are mispriced, investor could buy the low-priced portfolio & sell the high priced portfolio; in efficient mkts, profitable arbitrage opportunity will quickly disappear; Equation: APT: applies to well diversified portfolios & not necessarily to individual stocks; possible for some individual stocks to be misprice (doesnt lie on the SML); more general in that it gets to an expected return & beta relationship w/o the assumption of the mkt portfolio; can be extended to multi-factor models. 8:Market Efficiency: Prices reflect info; Once info becomes available mkt participants analyze it; Competition is a source of efficiency by ensuring prices reflect info; Prices move in random fashion as info arrives in random fashion. 3 Forms of EMH:1) Weak:past prices are useless in pred. future prices (implies Technical Analysis = worthless). 2) Semi-Strong: All publicly available info is in the price (implies fundamental analysis is worthless). 3) Strong: All info is in the price, including insider info (does not appear to be true in this country since insiders make abnormal profits). Technical Analysis (Charting): Using past prices & volume to predict future prices. Fundamental Analysis: using economic & accounting info to predict stock prices. Active Mgmt: looking for mispriced securities & trying to time the market; Passive Mgmt: buy&hold diversified portfolio (makes sense in Efficient Mkt), but even if the mkt is efficient a role exists for portfolio mgmt. (appropriate risk level, tax considerations, diversification). At least 3 issues guarantee that mkt efficiency can never be proven/disproven: 1) Magnitude issue: only managers of large port can make $ since stock prices are very close to fair value; actions of intelligent investment managers are the driving force. 2) Selection Bias: Outcomes we observe have been pre-selected in favor of failed attempts; cannot evaluate the true ability of portfolio managers; techniques that work are being kept secret so inventor can make $ by self. 3) Lucky Event Issue: Heads or Tails example. Semi-Strong Test (Market Anomalies): P/E Effect: market price distortion in which stocks with a low P/E tend later to outperform the market; Small Firm Effect (January Effect): invest in low-capitalization stocks = earn excess returns; Neglected Firms: small firms tend to be neglected by large institutional traders; Book to Mkt Ratios: Beta seems to have no power to explain avg security returns; Post-Earnings Announcement Drift: theres a large abnormal return on the earnings announcement day. Strong-Form Tests: Inside Information: the ability of insiders to trade profitability in their own stock; SEC requires all insiders to register their trading activity. Risk Premiums/Mkt Inefficiencies: Fama & French argue that these effects can be explained as manifestations of risk stocks w/ higher betas. Lakonishok, Shleifer, & Vishney argue that these effects are evidence of inefficient mkts. Joint Hypothesis Problem (testing both theory, eg CAPM, & mkt efficiency: is mkt not efficient or is measurement of risk, beta, insufficient. Data Mining: Finding patterns in past data that are worthless as future trading rules. 9:Behavioral Finance & Technical Analysis: Behavioral Finance: investors dont always process info correctly; often make inconsistent/systematically suboptimal decisions. Information Process Critique: Forecasting Errors; Overconfidence; Conservatism; Sample size neglect & representativeness. Behavioral Biases: Framing; Mental Accounting: diff levels of utility to asset groups affect consumption decisions; Regret Avoidance; Prospect Theory:base on perceived gains Limits to Arbitrage: Fundamental Risk; Implementation Costs; Model Risk. Bubbles: only possible to identify in retrospect, can be hard to take advantage of (irrational pricing can last indefinitely). Technical Analysis: Dow Theory: mkt in upward/downward trend if one of its avgs advances above/below a previous important high; Point & Figure charts: plots day2day price movements w/o taking time into consideration; Moving Avgs: indicator used to show avg val of a securitys momentum & def areas of possible support & resistance; Breadth: technique used to gauge the direction of the overall mkt by analyzing # of companies advancing relative to # declining; TrinStatistic: trin=(volume declining/#declining)/(volume advancing/#advancing); Confidence Index: ratio of avg yield on 10 top rated corporate bonds divided by the avg yield on 10 intermediate grade corporate bonds (sentiment indicators; Put/Call Ratio: change in ratio can be given a bullish/bearish interpretation (gauge investor sentimate); Short Interest: total # of shares that are sold short, when short sales are high a signal occurs, bullish/bearish interpretation; 15:Options MKTs: Calls (right to buy); Put (right to sell); Long (buy); Short (sell); Exercise/Strike Price; Premium/Price of option; Maturity/Expiration. In the Money: exercise of option = profitable (Call: mkt price>exercise price; Put: exercise price>mkt price); Out of the Money: exercise of option not profitable (Call: Mkt price<exercise price; Put: exercise price<mkt price); Most options trading in US take place on: 1) Chicago Board Options Exchange, 2) International Securities Exchange in NY. Some options trade on over-the-counter (OTC) mkts; Option contracts traded on exchanges are standardized. (America: exercised anytime; Europe: exercise only on expiration) Options Clearing Corporation (OCC): jointly owned by the exchanges on which options are traded; acts as middleman b/t options traders; guarantees contract performance (thus option writers are required to post margin); Types of Options: Stock, Index, Futures, Foreign Currency, Interest Rate. Factors that Impact Option Prices: 1) Price of underlying (as So increases, value of put decreases, value of call increases); 2) Strick Price (as X increases, val of put increases, val of call decreases); 3) Time to Expiration (as time to expiry increases, both puts&calls increase in value); 4) Volatility (the higher the volatility, the higher the price of puts&calls); 5) Risk-free rate: theoretical rate of return of an investment w/ 0 risk, represent interest an investor would expect from an absolutely risk-free investment over time. Payoffs & Profits on Options @ Expiration: Notation: Stock Price = St; Exercise Price = X Call Holder: Payoff to Call Holder: (St-X) if St>X, 0 if St<=X; Profit to Call Holder: Payoff Purchase Price | Call Writer: (same); Profit: Payoff+Premium Put Holder: 0 if St =>X, (X-St) if St<X; Profit to Put Holder: Payoff Premium | Put Writer: 0 if St => X, (X-St) if St<X; Profits to Put Writer: Payoff+Premium Leverage: 1) Use of various financial instruments/borrowed capital (margin) to increase potential ret of an investment. 2) Amount of debt used to finance a firm's assets. A firm w/ sig. more debt than equity is considered to be highly leveraged. (Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home) Strategies: Protective Put: A risk-management strategy that investors can use to guard against the loss of unrealized gains; Covered Call: options strategy where an investor holds a long position in an asset & writes (sells) call options on that same asset in an attempt to generate increased income from the asset; Straddle: options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date; Spread: An options position established by purchasing one option & selling another option of the same class but of a different series. The spread would be the difference between the strike price & the mkt value. 17:Futures: Forward Contract: Informal agreement (non-exchange-traded) b/t 2 parties calling for future delivery of an asset at an agreed-upon price. (Same for Future, but exchange-traded (so standardization, margin, increased liquidity, etc.). Futures price: the agreed-upon price to be paid on a futures contract at maturity. In essence, parties to a futures contract are locking in a price today, protecting downside, by giving up upside; Long (buy): take delivery at futures price (win if price decreases); Short (Sell): deliver at futures price (wins if price decreases). At Maturity (Time=T): Profit to Long = Spot price at maturity Original futures price (St-Fo); Profit to Short = Original futures price Spot price at maturity (Fo-St) Payoff Graphs: (straight line, not a hockey stick since parties must perform even if price moves against them); Margin: both L&S must post margin since they can have losses. Leverage: shows up through margin account. If margin is 5% of contract value, then leverage multiplier is x20 (=1/.05). If margin=20%, then multiplier is x5 (=1/.2). Reversing-Trade: most trades are reversed before contract maturity (if trader is long, then takes offsetting short position). 1) Speculation: Short: believe price will fall; Long: believe price will rise| Hedging: Long Hedge: protecting against a rise in price; Short Hedge: protecting against a fall in price. Basis: diff b/t spot & futures price (must be 0 at maturity); Cash Settlement: for Stock Index Futures (do not deliver/receive index) Spot Futures Parity: Spot Futures Parity for Stock Indexes: d=dividend yield (Dividend in $s/Stock Price) Spot Futures parity for Commodities: c=storage costs Arbitrage: Violation of the law of one pricebuy low, sell high to exploit mis-pricing of securities; Law of One Price: identical cash flows must have the same price Swaps: multi-period forward contract; interest rate swap: to convert from fixed to floating or vice-versa; foreign currency swap: lock-in exchange rates for multiple periods (E for $)