2. Risk, return and capital market equlibrium

Question 1

How to compute the present/current price of a security?

Answer 1

It is computed as the cash flow received over the period plus the expected price at the end of the period, discounted back at the riscount rate.

Question 2

What is the expected return of an asset composed of?

Answer 2

• A yield component (dividend divided by the begining period price)
• A capital gain component (is the percentage change in price over the period)

Question 3

How to compute the expected return on a portfolio of stocks?

Answer 3

The expected return on the porfolio is a weighted average of the past returns of all stocks included in the portfolio.

Question 4

What does variance and standard deviation measure?

Answer 4

They are proxies for the uncertainty or risk.

They measure the extent to which retruns are expected to vary around the average over time.

High variations = high risk
Low variations = low risk

Question 5

What does covariance measure?

Answer 5

It measures the riskiness of a security relative to tothers in a portfolio of securities.

Negative correlation is desirable in a security because it reduces the risk of the portfolio it’s in.

Question 6

How can portolio risk be classified?

Answer 6

• Diversifiable risk
• Undiversifiable risk

Question 7

What is diversifiable risk?

AKA specific risk, unsystematic risk or residual risk

Answer 7

It is the risk of the portfolio that can be further reduced by diversification.

Question 8

What is undiversifiable risk?

Answer 8

Undiversifiable risk is that type of risk which cannot be reduced regardless of how diversified the portfolio is.