Define Capital

Capital refers to the financial resources available to a company in the form of equity or debt.

What is a capital market

Investors (creditors or company shareholders) provide borrowers or investees with medium- to long-term financing in the form of equity or debt capital

What is a money market

money is lent to borrowers on a short-term basis for a period of up to a year.

Describe the concept of a perfect capital market

enable financial problems to be analyzed as clearly and coherently as possible. It implies a set of conditions where an equilibrium exists between supply and demand at the existing price for a commodity and market participants (buyers or sellers) cannot affect the price of the commodity

Which futures must exist to have a perfekt capital market

frictionless

transactions do not incur costs or taxes, and all securities can be perfectly (in terms of information efficiency) shared and traded.

free of regulatory restrictions

perfect competition

all market participants are “price takers”; their decisions and actions have no effect on market price.

rational participants

entities operating within this market have full information and seek to act logically in their best

interests.

information effciency

Name some channels that feed information about companies into the market.

prospectuses

market sector analyses

economic and business reports

company financial statements

or reports in the financial press.

What is a Prospectus

is a document about a company provided to potential investors; it has information about the company structure, securities for sale, business operations, risks, management, and financial status.

What means excess returns

higher investment returns than other market participants.

What is a liquid market

a market which always has investors and sellers in sufficient numbers to meet mutual demand.

What is informational efficiency

when all market participants have immediate access to the same information.

Whats Weak-form informational efficiency

= past information

Whats Semi-strong informational efficiency

= past + public infor-

mation

Whats Strong informational efficiency

= past + public+ private information

What does the portfolio theory developed by Markowitz say

portfolio selection theory. It attempts to explain the frequently observed risk diversification behavior of investors (i.e., including a range of different securities/assets in their portfolio), how a portfolio should be diversified rationally, and how many securities or assets should be included in a portfolio (Markowitz, 1952). It is a theory of individual decision-making.

What is the overall volatility (or dispersion of return) of a financial asset or investment

a function of its share of diversifiable variance or risk (unsystematic risk), and its share of non-diversifiable variance (systematic risk or market risk).

Unsystematic risk in a portfolio can be reduced by adding an asset that is likely to fluctuate in its performance in ways that do not fully correlate with the remainder of the portfolio.

The variance of return is thus minimized by the asset added to the portfolio.

Describe the Diversifiable vs. non diversifiable risk picture

Formel Abkürzungen

The following equation is used for the correlation coefficient:

The portfolio return µp is the result/product of:

the portfolio risk (standard deviation) is given as:

In the case r1 2 = 1, the equation can be simplified as follows:

In the case r1 2 = 0, the equation can be simplified as follows:

In the case r1 2 = –1, the equation can be simplified as follows:

Describe the Two Asset Protfolio example picture

Describe the interrelationship between correlation and diversification

Describe CAPM

capital asset pricing model (CAPM) developed from the portfolio theory of Markowitz (1952)

not about rational, individual decision-making

about the way decisions aggregate to create market equilibrium

field of application includes evaluation theory and practical company valuation

attempts to identify that part of the overall risk of an investment that cannot be eliminated through diversification

explains how to evaluate risky investment opportunities in the capital market

Assumptions with CAPM

Single-period transaction horizon (one year)

Risk-averse and maximise profit

Normal distribution of the returns

Risk free investments exists

Perfect capital market exists

What does CAPM show?

How can you value an investment with risk?

What market price compensates for the risks taken?

The concept of a stock´s beta (CAPM)

To calculate beta, a regression analysis is performed for a certain period. For example, over a period of two years, the 104 weekly return figures of a stock are regressed with the corresponding returns of a market portfolio in the U.S., e.g., the Dow Jones stock market index. If this is graphed, with the x-axis representing the market rate of return and the y-axis the rate of return on the asset, the slope of the regression line corre-

sponds precisely to beta.

The concept of expected return (CAPM)

Summary

Perfect capital markets do not exist in practice. They are a theoretical construct designed to analyze problems from a financial and economic perspective and to suggest solutions. The core assumptions of a perfect capital market are (1) the market is frictionless (i.e., there are no transaction costs), (2) it is perfectly competitive, (3) all market participants behave rationally, and (4) the market is fully efficient in terms of availability of information (i.e., everyone has equal access to all possible sources of information).

Informational efficiency plays a key role in capital market theory. Informational efficiency means that all market participants possess all information relevant to valuing assets. A distinction is made between weak form, semi-strong form, and strong form informational efficiency.

Portfolio theory shows how an investor can create an optimized portfolio. According to the theory, unsystematic risk can be eliminated. Depending on the degree of correlation between two securities, adding a stock to a portfolio can minimize fluctuations in returns/yield. A diversification effect is only possible in the absence of a perfect positive correlation between the two securities.

The CAPM is an equilibrium pricing model for the capital market. It demonstrates how investments associated with risk are valued and shows which market price applies to an investment as compensation for the risk assumed.

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