8 Priority 1

Front 1

List the 3 themes central to portfolio theory

Back 1

1) Risk and Reward
2) Quantifying Risk and Return Tradeoffs
3) How Asset Risk is Assessed

Front 2

List 3 common criticisms of the passive strategy

Back 2

1) They’re Undiversified
2) They’re Top Heavy
3) They’re Chasing Performance
4) You Can Do Better

Front 3

List 3 characteristics that US T-Bills have to make them an appropriate choice as “the” risk free asset

Back 3

1) Free of default risk
2) Short term nature makes them insensitive to interest rate risk
3) Their exposure to inflation uncertainty is minimal

Front 4

Give the 3 steps involved in portfolio construction when considering the case of many risky securities and a risk-free asset

Back 4

1) Identify the risk-return combinations available from the set of risky assets
2) Identify the optimal portfolio of risky assets by finding the portfolio weights that result in the steepest CAL
3) Choose an appropriate complete portfolio by mixing the risk free asset with the optimal risky portfolio

Front 5

List the 3 uses of CAPM

Back 5

1) Identifying Underpriced Assets
2) Capital Budgeting
3) Utility Rate Setting

Front 6

Give 2 lessons learned from the liquidity analysis

Back 6

1) Equilibrium expected rates of return are bid up to compensate for transaction costs
2) Illiquidity premium is not a linear function of transaction costs. Further, incremental illiquidity premium steadily declines as transaction costs increase.

Front 7

List the 2 general types of risk

Back 7

1) Market Risk
2) Firm Specific Risk

Front 8

Give 3 reasons why using and testing CAPM is more difficult than it first appears

Back 8

1) CAPM assumes that the “market portfolio” contains all risky assets, but this hypothetical portfolio could not be constructed
2) CAPM is stated in terms of expected returns, but we can only observe actual returns
3) Related to the last point, CAPM assumes a linear relationship between expected returns for a stock and the expected market risk premium

Front 9

List the 3 key propositions that APT rely on

Back 9

1) Security returns can be described by a factor model
2) There are sufficient securities to diversify away idiosyncratic risk
3) Well-functioning security markets do not allow for the persistence of arbitrage opportunities

Front 10

List 2 ways in which APT serves many of the same functions as the CAPM

Back 10

1) APT provides a benchmark for rates of return that can be used in capital budgeting, security evaluation, or investment performance evaluation
2) APT demonstrates that nondiversifiable risk (factor risk) requires a reward in the form of a risk premium and diversifiable does not.

Front 11

Give the 3 versions of Efficient Market Hypothesis (EMH)

Back 11

1) Weak Form
2) Semi-Strong Form
3) Strong Form

Front 12

List 3 key issues that will prevent us from ever settling if markets are efficient

Back 12

1) Magnitude Issue
2) Selection Bias
3) Lucky Event Issue

Front 13

List the 5 Market Anomalies

Back 13

1) Momentum
2) P/E Effect
3) Small Firm Effect (in January)
4) Neglected Firm Effect
5) Book to Market Ratios

Front 14

List 3 factors that limit the ability of rationale investors to profit from mispricing

Back 14

1) Fundamental Risk
2) Implementation Costs
3) Model Risk

Front 15

List 4 factors that will vary an investor’s optimal position

Back 15

1) Age
2) Tax Bracket
3) Risk Aversion
4) Employment

Front 16

List the 3 basic steps of the model

Back 16

1) Setting up the sample data
2) Estimating the SCL
3) Estimating the SML

Front 17

Despite the findings of the empirical research, list 2 major conclusions of CAPM that are largely supported

Back 17

1) Expected returns increase linearly with systematic risk
2) Expected returns are not affected by non-systematic risk

Front 18

List 3 important features of corporate bonds

Back 18

1) Call Feature
2) Convertible Bonds
3) Putable Bonds

Front 19

List the 3 types of yields

Back 19

1) Yield to Maturity
2) Current Yield
3) Yield-to-Call

Front 20

List the 5 types of ratios looked at when rating bonds

Back 20

1) Coverage Ratios
2) Leverage Ratios
3) Liquidity Ratios
4) Profitability Ratios
5) Cash Flow to Debt Ratio

Front 21

List 4 types of protective covenants to prevent firms from dramatically altering probabilities of default

Back 21

1) Sinking Funds
2) Subordination
3) Dividend Restrictions
4) Collateral

Front 22

Give 2 reasons why longer-term bonds offer higher yields to maturity

Back 22

1) Longer-term bonds are riskier. Thus, higher risk premiums for longer term bonds are necessary to compensate investors for interest rate risk.
2) Investors expect interest rates to rise. Therefore, higher yields on long-term bonds reflect anticipation of higher interest rates in the latter years of a bond’s life.

Front 23

List the 2 theories of the Term Structure of Interest Rates

Back 23

1) The Expectations Hypothesis: States that forward rates equal expected of the future short interest rates.
2) Liquidity Preference: Advocates of this theory believe that short-term investors dominate the market.

Front 24

List 3 major risks associated with fixed-interest investments

Back 24

1) Default Risk (biggest concern)
2) Interest Rate Risk
3) Liquidity Risk

Front 25

List 4 ways that bonds can exit the original population

Back 25

1) Defaults
2) Calls
3) Sinking Funds
4) Maturities

Front 26

Give 4 possible reasons why lower rated bonds have a significantly positive realized spread to investments in Treasuries

Back 26

1) They are also being compensated for liquidity risk and reinvestment risk
2) They could be compensated for taking on the risk of variability in recovery rates
3) They could be compensated for the systematic risk of default
4) They could be overly compensated due to artificial imbalances between supply and demand

Front 27

Give 3 reasons why investors have been more than fairly compensated for investing in high-risk bonds

Back 27

1) Market inefficiency
2) Restrictions as to risk class of investments imposed by institutions
3) Retention values below recovery rate

Front 28

List 3 interest rates that are important in options and futures markets

Back 28

1) Treasury Rates
2) London Interbank Offer Rates (LIBOR)
3) Repo (repurchase) Rates

Front 29

List 6 of the key standardization specifics in a futures contract

Back 29

1) Asset
2) Contract Size
3) Delivery Arrangements
4) Delivery Months
5) Price Quotes
6) Price Limits and Position Limits

Front 30

List the 3 main categories of individuals taking positions

Back 30

1) Hedgers
2) Speculators (Scalpers, Day Traders, and Position Traders)
3) Arbitrageurs

Front 31

List 4 ways that regulators deal with investor groups to prevent them from “cornering the market”

Back 31

1) Increase margin requirements
2) Impose stricter position limits
3) Prohibit trades that increase a speculator’s open position
4) Force market participants to close out their positions

Front 32

List the 2 key tax issues

Back 32

1) Nature of a taxable gain or loss
2) Timing of the recognition of the gain or loss

Front 33

Give 2 reasons why a hedger uses futures contracts instead of simply selling the portfolio and investing the proceeds in Treasury Bills

Back 33

1) The hedger feels that the stocks in the portfolio have been chosen well and will outperform the market
2) The hedger is planning to hold a portfolio for a long period of time and requires short-term protection.

Front 34

Give 3 reasons for a company not to hedge it’s exposure to a particular risk

Back 34

1) If the company’s competitors are not hedging, the treasurer might feel that the company will experience less risk if it does not hedge
2) The shareholders might not want the company to hedge
3) It might look bad on the treasurer if there is a loss in good times even though the purpose of the hedge is to minimize volatility whether bad or good

Front 35

List 4 assumptions that the authors make about market participants

Back 35

1) They are subject to no transaction costs when they trade
2) They are subject to the same tax rate on all net trading profits
3) They can borrow and lend money at the risk-free rate**
4) They take advantage of arbitrage opportunities when they occur

Front 36

List the 4 ways that Cost of Carry, c, can vary depending on the asset under consideration

Back 36

1) For a non-dividend paying stock, the cost of carry is r (no storage costs and no income is earned).
2) For a stock index, it is (r – q) since income is earned at rate q on the asset.
3) For a currency, it is r – r(f).
4) For a commodity that provides income at rate q and requires storage costs at rate u, it is r – q + u.

Front 37

Give 3 reasons why if hedgers tend to hold short positions and speculators tend to hold long positions, the futures price of an asset will be below the expected spot price

Back 37

1) Speculators require compensation for the risks they are bearing
2) Speculators will trade only if they can expect to make money on average
3) Hedgers will lose money on average, but they are likely to be prepared to accept this because the futures contract reduces their risks.

Front 38

List the 2 ways that one can think of when valuing Interest Rate Swaps

Back 38

1) Value as an Exchange of Bonds
2) Value as Series of Forward Rate Agreements (FRA’s)

Front 39

As a result of the Tax Relief Act of 1997, list 3 actions of the owner that consider appreciated property “constructively sold”

Back 39

1) Enters into a short sale of the same or substantially identical property
2) Enters into a futures or forward contract to deliver the same or substantially identical property
3) Enters into one or more positions that eliminate substantially all of the loss and opportunity for gain

Front 40

List 6 factors that affect the price of a stock option

Back 40

1) The current stock price, So
2) The strike price, K
3) The time to expiration, T
4) The volatility of the stock price, σ
5) The risk-free interest rate, r
6) The dividends expected during the life of the option

Front 41

List 4 assumptions of the market participants, such as large investment banks

Back 41

1) There are no transaction costs
2) All trading profits (net of trading losses) are subject to the same tax rate
3) Borrowing and lending at the risk-free interest rate is possible
4) There are no arbitrage opportunities

Front 42

List 5 types of Spreads

Back 42

1) Bull Spread
2) Bear Spread
3) Butterfly Spread
4) Calendar Spread
5) Diagonal Spread

Front 43

List 4 types of Combinations

Back 43

1) Straddle
2) Strip
3) Strap
4) Strangle

Front 44

List the 3 types of stochastic processes

Back 44

1) Wiener Process
2) Generalized Wiener Process
3) Ito Process

Front 45

List 7 assumptions used to derive the Black-Scholes-Merton differential equation

Back 45

1) Stock prices are developed with μ and σ constant
2) Short selling of securities with full use of proceeds is permitted
3) No transactions costs or taxes. All securities are perfectly divisible
4) No dividends during the life of the derivative
5) No riskless arbitrage opportunities
6) Security trading is continuous
7) The risk-free rate of interest, r, is constant

Front 46

List 2 things that happen when moving from a risk neutral world to a risk-averse world

Back 46

1) The expected growth rate in the stock price changes
2) The discount rate that must be used for any payoffs from the derivative changes

Front 47

Give 2 reasons why the cost of hedging increases as the beta of a portfolio increases

Back 47

1) More put options are required
2) The options have a higher strike price

Front 48

List the 2 main differences between a forward contract used to hedge vs. an option approach to hedge

Back 48

1) A forward contract locks in the exchange rate for a future transaction, while an option provides a type of insurance.
2) A forward transaction costs nothing to enter into. An option requires a premium to be paid up front.

Front 49

Give 2 reasons for the popularity of futures options

Back 49

1) The main reason is that a futures contract is generally more liquid and easier to trade
2) A futures price is known immediately from trading on the futures exchange (vs. the spot price not being so readily available).

Front 50

List 10 unrealistic assumptions in the original derivation of the formula

Back 50

1) The stock’s volatility is known, and doesn’t change over the life of the option
2) The stock price changes smoothly: it never jumps up or down a large amount in a short time
3) The short-term interest rate never changes
4) Anyone can borrow or lend as much as he wants at a single rate
5) An investor who sells the stock or the option short will have the use of all the proceeds of the sale and receive any returns from investing these proceeds
6) There are no trading costs for either the stock or the option
7) An investor’s trades do not affect the taxes he pays
8) The stock pays no dividends
9) An investor can exercise the option only at expiration
10) There are no takeovers or other events that can end the option’s life early

Front 51

List 2 sorts of risk that are unique to international investments

Back 51

1) Exchange Rate Risk
2) Country-specific Risk

Front 52

List the 3 types of risk that make up country-specific risk

Back 52

1) Political Risk: includes government stability, military in politics, democratic accountability, etc.
2) Financial Risk: includes foreign debt, net liquidity, exchange rate stability, etc.
3) Economic Risk: includes GDP per capita, annual inflation, and current account balance, etc.

Front 53

List 5 avenues for U.S. investors to invest internationally

Back 53

1) Purchase securities directly in the capital markets of other countries
2) Purchase American Depository Receipts, or ADRs
3) Purchase single-country mutual funds that invest in the shares of only one country
4) Purchase mutual funds with investments concentrated overseas, generally in Europe, in the Pacific Basin, and in developing economies in an emerging opportunities fund
5) Trade derivative securities based on prices in foreign security markets

Front 54

List the 3 types of weighting schemes for constructing international indexes

Back 54

1) Market Capitalization (most common)
2) GDP
3) Import share of various countries

Front 55

Portfolio managers’ performance from international investments can be broken down into which 4 key sources of total performance

Back 55

1) Currency Selection
2) Country Selection
3) Stock Selection
4) Cash/bond Selection

Front 56

List the 3 factors that need to be considered when evaluation the potential benefits of international diversification

Back 56

1) The riskiness of each asset on its own when measured in its own local currency
2) The impact of the exchange rate risk on the riskiness when measured in US dollars
3) The degree of correlation between the indices

Front 57

List 6 general properties of Bond Prices

Back 57

1) Bond prices and yields are inversely related
2) Increases in yield to maturity has a smaller impact than a comparable decrease in yield
3) Long term bonds are more sensitive to changes in yields than short term bonds
4) Sensitivity to changes in yields increases at a decreasing rate as maturity increases
5) High coupon bonds are less sensitive to changes in yields than low coupon bonds
6) The sensitivity of a bond’s price to changes in yields is inversely related to the yield at which it is currently selling

Front 58

List 3 reasons why Duration is a key concept in fixed-income portfolio management

Back 58

1) It is a simple statistic of the effective average maturity of the portfolio
2) It is an essential tool in immunizing portfolios from interest rate risk
3) It is a measure of the interest rate sensitivity of a portfolio

Front 59

List 3 key factors that influence the sensitivity of a bond’s price to changes in market interest rates

Back 59

1) Time to Maturity
2) Coupon Rate
3) Yield to Maturity

Front 60

List 2 types of passive bond investment strategies

Back 60

1) Indexing
2) Immunization

Front 61

Give 2 ways that Immunization attempts to eliminate interest rate risk form a portfolio

Back 61

1) Ensuring that changes in interest rates do not affect the total market value (duration based)
2) Ensuring that changes in rates do not affect the expected future value (with reinvestment)

Front 62

Give 2 reasons for active bond management

Back 62

1) Interest Rate Forecasting
2) Identification of relative mispricing within the fixed-income market

Front 63

List the 5 types of Swaps discussed to take advantage of different views of what might happen to bond values

Back 63

1) Substitution Swap
2) Intermarket Spread Swap
3) Rate Anticipation Swap
4) Pure Yield Pickup Swap
5) Tax Swap

Front 64

List 3 reasons why the basic immunization approach is unrealistic

Back 64

1) It assumes that interest rates only change by small amounts
2) It assumes parallel shifts in the term structure
3) It ignores inflation

Front 65

List 3 ways that interest rate and inflation rate changes affect common stock

Back 65

1) Value of the firm
2) Supply and demand
3) Investment strategy

Front 66

List 2 similarities between Equity Cash Flows and P&C Liabilities

Back 66

1) Both are inflation sensitive
2) Both are subject to considerable risk other than interest rate risk

Front 67

List the 2 ways to match Assets & Liabilities

Back 67

1) Cash Flow Matching
2) Duration Matching

Front 68

List 4 reasons why stocks are not really inflation neutral

Back 68

1) Economic Shocks (oil price hikes) cause increases in inflation and simultaneous decreases in earnings and dividends
2) Higher inflation leads to greater uncertainty and higher discount rates
3) The tax system is not inflation neutral so inflation leads to lower after tax real earnings
4) Investors tend to undervalue stocks in periods of high inflation because of money illusion (they mistake a rise in nominal rates for a rise in real rates).

Front 69

List the 2 components that the paper separates the value of a P&C company into

Back 69

1) Portfolio Equity
2) Franchise Equity

Front 70

List the 3 ways that portfolio equity can be valued

Back 70

1) Book Value (Statutory Surplus)
2) Current Value Surplus
3) Market Value Surplus (Economic Accounting)

Front 71

List the 3 parts that the joint committee’s recommendation is to apportion the assets of the insurance company

Back 71

1) Valuation Reserves
2) Contingency Surplus
3) Vitality Surplus

Front 72

List 3 ways to have investment returns keep pace with inflation

Back 72

1) Invest more heavily in common stocks or real estate, two asset classes that arguably contain an exposure to inflation
2) Have assets that roll over frequently, but this will require more short-term assets and will likely require a deviation from duration matching
3) Simply overstate the liabilities in the form of contingency reserves

Front 73

List 3 important points about Franchise Value

Back 73

1) Franchise value is significant for many P&C insurers
2) Franchise value is exposed to interest rate risk
3) Franchise value is often unmeasured, unreported and consequently unmanaged by the firm

Front 74

Give 3 examples of ways risk management can reduce financial distress costs

Back 74

1) Reduce Bankruptcy Costs
2) Reduce Payments to Stakeholders
3) Reduce Taxes

Front 75

List the 2 pillars of modern finance theory

Back 75

1) Market Efficiency
2) Diversification

Front 76

List the 3 major costs that Academic Finance Literature has identified are associated with higher variability

Back 76

1) Higher expected bankruptcy costs
2) Higher expected payments to corporate “stakeholders”
3) Higher expected tax payments

Front 77

List 2 advantages in using risk management and increasing leverage ratios

Back 77

1) Debt financing has a tax advantage over equity financing
2) Increasing leverage can strengthen management incentives to improve efficiency and add value

Front 78

List the 5 Greek Letters and what they monitor

Back 78

1) Delta – derivative of option value with respect to price
2) Gamma – rate of change of the portfolio’s delta
3) Theta – sensitivity of the option value with respect to changes in time
4) Vega – sensitivity of the option value with respect to volatility of the asset
5) Rho – change in value of option with respect to the interest rate

Front 79

List 2 approaches in calculating VaR

Back 79

1) Historical Simulation Approach
2) Model-building Approach

Front 80

Give 3 alternative approaches for handling interest rates when the model building approach is used to calculate VaR

Back 80

1) The use of the Duration Model
2) The use of Cash Flow Mapping
3) The use of Principal Components Analysis

Front 81

Give 3 reasons that VaR’s popularity stems from

Back 81

1) Its ease of interpretation as a summary measure of risk
2) Its consistent treatment of risk across financial instruments and business activities
3) Its use as a decision support tool in a comprehensive risk management process

Front 82

List 3 features of VaR that were of particular value to trading firms

Back 82

1) Consistent
2) Probability Based
3) Common Time Horizon

Front 83

List 5 uses of VaR

Back 83

1) Risk Reporting
2) Risk Control
3) Risk Management
4) Capital Allocation
5) Exposure Monitoring

Front 84

List 3 alternatives to VaR

Back 84

1) Cash Flow Risk
2) Risk Based Capital
3) Shortfall Risk

Front 85

List 2 ways financial institutions reduce potential losses in the event of a default

Back 85

1) Collateralization
2) Use of downgrade triggers

Front 86

List 4 reasons why traders would expect an excess return on bonds

Back 86

1) Liquidity Premium
2) Conservatism
3) Systematic Risk and Contagion
4) Skewness

Front 87

List 3 methods used to mitigate exposure to credit risk

Back 87

1) Netting
2) Collateral requirements
3) Downgrade triggers

Front 88

List 2 general approaches that are used to model default correlations

Back 88

1) Structural methods
2) Reduced Form models

Front 89

List the 4 main categories of a firm’s aggregate risk profile

Back 89

1) Market Risk
2) Credit Risk
3) Insurance Underwriting Risk
4) Other Risk

Front 90

List the 4 choices of income measures for RAROC

Back 90

1) GAAP Net Income
2) Statutory Net Income
3) IASB Fair Value Basis Net Income
4) Economic Profit

Front 91

List the 2 types of objectives that the risk capital is intended to achieve

Back 91

1) Solvency Objective
2) Capital Adequacy Objective

Front 92

List the 4 Capital Allocation Approaches

Back 92

1) Proportional Allocation Based on a Risk Measures
2) Incremental Allocation
3) Marginal Allocation (Myers-Read Method)
4) Co-Measures Approach (Kreps, Ruhm-Mango)

Front 93

List 5 methods of applying risk-adjusted performance metrics

Back 93

1) Assessing Capital Adequacy
2) Setting Risk Management Practices
3) Evaluating Alternative Risk Management Strategies
4) Risk-Adjusted Performance Measurement
5) Insurance Policy Pricing

Front 94

List 3 limitations to the measure of Economic Value

Back 94

1) To accurately reflect the change in value for a firm, changes in the value of its future profits must also be taken into account. This franchise value can be a significant source of value for firms
2) The use of economic profit as an income measure also complicates reconciliation to GAAP income or other more familiar measures of profitability
3) If the economic profit measures are not disclosed to external parties such as investors, regulators or rating agencies, management may have more difficulty communicating the basis for their decisions

Front 95

List 4 common risk measures

Back 95

1) Probability of Ruin
2) Percentile Risk Measure (Value at Risk)
3) Conditional Tail Expectation (CTE)
4) Expected Policyholder Deficit Ratio (EPD)

Front 96

List 5 advantages to separately modeling frequency and severity instead of modeling the loss ratio

Back 96

1) Growth in volume of business can be more easily accounted for
2) Inflation can be more accurately reflected, particularly when there are deductibles and policy limits
3) Changes in limit and deductible profiles can be directly reflected
4) Impact of deductibles on claim frequency can be reflected
5) Estimates of the split of losses between insured, insurer and reinsurer can be mutually consistent

Front 97

List 3 criteria for an effective risk based capital method

Back 97

1) It should be the same for all classes of insureds, all types of insurers, and all types of claimants
2) It should be objectively measured
3) It should discriminate between quantifiable measures of risk

Front 98

List 3 potential sources of economic benefits from risk management

Back 98

1) Minimize taxes by reducing earnings volatility
2) Minimize the costs of financial distress
3) Avoid the under-investment problem caused by the difficulty of firms in financial distress to raise capital

Front 99

List 3 reasons why they are interested in insurance securitization now

Back 99

1) Catastrophe Experience
2) Capital Market Developments
3) Insurance Industry Structure

Front 100

List 4 Risk Transfer Products

Back 100

1) Reinsurance
2) Swaps
3) Catastrophe Bonds
4) Exchange-traded Derivatives

Front 101

List 3 types of triggers

Back 101

1) Direct
2) Industry
3) Event

Front 102

List 4 benefits of an asset-backed securitization process

Back 102

1) Enhance liquidity of a previously non-rate, illiquid asset
2) The development of market values for certain assets
3) Creation of more efficient and lower cost ways of moving funds from investors to borrowers
4) The potential for improved credit rating for the asset in question

Front 103

Give 2 reasons for securitizing insurance risks

Back 103

1) Capacity
2) Investment

Front 104

List 2 ways to categorize the many types of insurance-related instruments

Back 104

1) Those that transfer risk
2) Those that provide contingent funding

Front 105

List 4 possible reasons for the failures of catastrophe bond offerings

Back 105

1) Newness and unfamiliarity
2) Uncertainty regarding pricing
3) Portfolio issues
4) Traditional reinsurance

Front 106

List 5 traits common to successful offerings

Back 106

1) Highly volatile catastrophic risk
2) Relatively high levels of protection
3) Relatively short maturities
4) Some protection of principal is included
5) High coupon rates

Front 107

Give 3 reasons why it is a mistake for insurers to use RBC in capital allocation

Back 107

1) There is no theoretical foundation for the formula
2) The formula is of questionable accuracy; based on book values rather than market values
3) The formula also ignores correlations among the firm’s businesses, which should be taken into account

Front 108

List 2 advantages of the M-R (Myers/Read) Method

Back 108

1) It avoids the problem of how to deal with the unallocated capital under the M-P approach
2) Most decision making regarding pricing and underwriting is marginal in the sense of M-R

Front 109

List 3 reasons to allocate capital

Back 109

1) Pricing, underwriting and other decision making could possibly be enhanced by thinking of capital as being allocated, even though it is not literally allocated
2) Allocation of capital could help to tie together certain financial decisions and regulatory risk-based capital rules
3) Concepts like risk-adjusted return on capital (RAROC) and economic value added (EVA) make use of capital allocation for performance measurement

Front 110

List the 2 approaches of value maximization

Back 110

1) RAROC
2) EVA

Front 111

List 5 Capital Allocation Techniques

Back 111

1) Regulatory (NAIC) Risk-Based Capital
2) CAPM
3) Value at Risk
4) Insolvency Put Option (EPD)
5) Marginal Capital Allocation (Merton & Perold vs. Myers & Read)

Front 112

List the 3 main sources of frictional costs

Back 112

1) Agency Costs
2) Double Taxation
3) Regulatory Costs

Front 113

List 3 ways the Constant Growth DDM will imply a greater stock value

Back 113

1) The larger its expected dividend per share
2) The lower the market capitalization rate, k
3) The higher the expected growth rate of dividends

Front 114

List 4 Comparative Valuation Ratios

Back 114

1) Price-to-Book
2) Price-to-Cash-Flow
3) Price-to-Sales
4) Price-to-Earnings

Front 115

List the 2 factors that have the greatest impact on stock prices

Back 115

1) Interest Rates
2) Corporate Profits

Front 116

List the 5 Valuation Methods discussed in the Goldfarb Paper

Back 116

1) Dividend Discount Model (DDM)
2) Discounted Cash Flow (DCF)
3) Abnormal Earnings (AE)
4) Relative Valuation Using Multiples
5) Option Pricing Theory

Front 117

Give 5 reasons to be cautious when focusing on transaction multiples

Back 117

1) Control Premiums
2) Overpricing in M&A Transactions
3) Underpricing in IPO Transactions
4) Uncertainty of Reported Financial Variables
5) Changes in Underlying Economic Assumptions

Front 118

List 5 types of Real Options for Valuation

Back 118

1) Abandonment Option: Valued as an American put on the value of the project with a strike equal to the net liquidation proceeds
2) Expansion Option: Valued as an American call option on the (gross) value of the lost capacity with a strike price equal to the cost of creating the capacity
3) Contraction Option: Valued as an American put on the (gross) value of the lost capacity with a strike equal to the cost savings
4) Option to Defer: Otherwise known as the option to wait, this is an American call on the value of a project
5) Option to Extend: Valued as a European call option on the asset’s future value

Front 119

List 4 types of technical issues that must be considered in the actual valuation formula

Back 119

1) Valuing the Underlying Business Cash Flows
2) Time to Option Maturity
3) Exercise Type
4) Appropriate Valuation Formula

Front 120

List 3 characteristics that make real options more valuable

Back 120

1) Options are more valuable when new information will be discovered prior to their expiration date that will allow for a more informed decision
2) Expansion options are valuable only if there is some exclusive right or ability to exercise them
3) The exercise price must be fixed in order for the option to have value