5. Introduction to Risk and Return

Question 1

What is the “market risk premium”

Answer 1

the difference between the nominal return on stocks MINUS the nominal return on bills.

Stock = more risky, hence why they have a greater premium.

Question 2

How do you calculate the “market risk premiums”?

Answer 2

Nominal Return on Stocks - Nominal Return on Bills

Question 3

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?

Answer 3

7.8%

(11.5 - 3.7)

Question 4

What is the equation to calculate “market return”?

Answer 4

Rm = rf + normal risk premium

where:
rf = sum of the risk-free interest rate

Question 5

What are the 2 major considerations when estimating FUTURE returns using PAST returns?

Answer 5

• how far back should you go when gathering past data
• how much to adjust data when forecasting the future

Question 6

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%?

Answer 6

2% + 7.7%

= 9.7%

Question 7

What is variance?

Answer 7

Expected Square deviation from the expected return

where:
~ri = is the actual return of stock i
ri = the expected return

Question 8

What is standard deviation?

Answer 8

The SQUARE ROOT of variance

Question 9

What symbol is used to denote standard deviation and variance?

Answer 9

Question 10

What is the equation used to calculate expected portfolio returns?

Answer 10

where:
x1, x2 = proportions invested into stocks 1 and 2
r1, r2 = expected returns on stocks 1 and 2

Question 11

What is “diversification”?

Answer 11

Strategy designed to reduce risk by spreading the portfolio across many investments

Question 12

What is “specific risk”?

Answer 12

Risk factors affecting only that firm.

Question 13

What is “market risk”?

Answer 13

Economywide sources of risk that affect the overall stock market. Also called “systematic risk”.

Question 14

What is the risk called that CAN be eliminated through diversification?

Answer 14

Specific risk

(diversifiable risk)

Question 15

What is the risk called that can NOT be eliminated through diversification?

Answer 15

Market Risk/ Systematic Risk

Question 16

What does the “covariance” measure?

Answer 16

“The covariance measures the degree to which the two stocks “covary” or in other words move together.”

Question 17

What is the equation used to calculate portfolio variance?

Answer 17

x1, x2 = proportions invested into stocks 1 and 2
o1(^2), o2(^2) = variance of stock returns
p12 = correlation coefficient

Question 18

What is the expected return of a portfolio of:

60% SA stock, return: 15%
40% AMZ stock, return 10%

Answer 18

(0.6 * 15) + (0.4 * 10)

== 13%

Question 19

Is a portfolio variance is 749.7, what is the standard deviation?

Answer 19

Square Root of variance!

Question 20

What is the definition of “market portfolio”?

Answer 20

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.

Question 21

What is “beta”?

Answer 21

Sensitivity of a stock’s return to the return on the market portfolio.

Question 22

How is beta calculated?

Answer 22