5. Introduction to Risk and Return Flashcards
What is the “market risk premium”
the difference between the nominal return on stocks MINUS the nominal return on bills.
Stock = more risky, hence why they have a greater premium.
How do you calculate the “market risk premiums”?
Nominal Return on Stocks - Nominal Return on Bills
If the treasury bills had a 3.7% nominal return, whilst stocks had an 11.5% nominal return. What is the average market risk premium?
7.8%
(11.5 - 3.7)
What is the equation to calculate “market return”?
Rm = rf + normal risk premium
where:
rf = sum of the risk-free interest rate
What are the 2 major considerations when estimating FUTURE returns using PAST returns?
- how far back should you go when gathering past data
- how much to adjust data when forecasting the future
What is the market return if the sum of risk-free interest rate is 2% (quite common!), and the normal risk premium is 7.7%?
2% + 7.7%
= 9.7%
What is variance?
Expected Square deviation from the expected return
where:
~ri = is the actual return of stock i
ri = the expected return
What is standard deviation?
The SQUARE ROOT of variance
What symbol is used to denote standard deviation and variance?
What is the equation used to calculate expected portfolio returns?
where:
x1, x2 = proportions invested into stocks 1 and 2
r1, r2 = expected returns on stocks 1 and 2
What is “diversification”?
Strategy designed to reduce risk by spreading the portfolio across many investments
What is “specific risk”?
Risk factors affecting only that firm.
What is “market risk”?
Economywide sources of risk that affect the overall stock market. Also called “systematic risk”.
What is the risk called that CAN be eliminated through diversification?
Specific risk
(diversifiable risk)
What is the risk called that can NOT be eliminated through diversification?
Market Risk/ Systematic Risk
What does the “covariance” measure?
“The covariance measures the degree to which the two stocks “covary” or in other words move together.”
What is the equation used to calculate portfolio variance?
x1, x2 = proportions invested into stocks 1 and 2
o1(^2), o2(^2) = variance of stock returns
p12 = correlation coefficient
What is the expected return of a portfolio of:
60% SA stock, return: 15%
40% AMZ stock, return 10%
(0.6 * 15) + (0.4 * 10)
== 13%
Is a portfolio variance is 749.7, what is the standard deviation?
Square Root of variance!
What is the definition of “market portfolio”?
Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P composite, is used to represent the market.
What is “beta”?
Sensitivity of a stock’s return to the return on the market portfolio.
How is beta calculated?
