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Mgmt 326 > Ch 11/12: Risk and Return > Flashcards

Ch 11/12: Risk and Return Flashcards

1
Q

What is risk

A

The reliability of the rate of return

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2
Q

What is financial risk?

A

The chance that an outcome other than that which was desired will occur

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3
Q

What is uncertainty?

A

The lack of knowledge of what will happen in the future

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4
Q

Average Annual Return

A

The arithmetic average of an investment’s realized annual stock returns over a certain period

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5
Q

How do you compute average annual return?

A

1/TimeInYears(realized return of year one + realized return of year two….)

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6
Q

Average annual return is equal to

A

realized return

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7
Q

How many years of data do you use to compute average annual return?

A

The number of years in the future you wish to estimate

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8
Q

Standard deviation tells us what?

A

How reliable or risky it is

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9
Q

What does a high standard deviation mean?

A

Has a greater range of possible outcomes, more risky

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10
Q

What does a small standard deviation mean?

A

More reliable, less uncertainty due to narrower probability distribution

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11
Q

Risk Aversion

A

Given two securities with equal expected returns but different degrees of risk, the rational investor would choose the one with lower risk

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12
Q

Coefficient of Variation

A

A way to quantify the relationship between risk and return, shows the risk per unit of return, provides standardized measure of risk

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13
Q

Coefficient of variation is only useful for what?

A

Stocks in the same industry

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14
Q

How do you find the coefficient of variation?

A

Standard deviation/return%

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15
Q

When does CV not work?

A

When stocks are in different industry, or if expected returns are significantly different

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16
Q

Which is less risky: portfolio investing or single security investing?

A

Portfolio investing

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17
Q

Why is portfolio investing less risky?

A

The risks of the individual securities comprising the portfolio are averages

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18
Q

Diversification

A

The tendency for price movements of individual securities to counteract each other

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19
Q

What is the equation to find the expected return of a portfolio?

A

Sum of [weight (by value) times expected return] for each company

20
Q

Portfolio Realized Rate of Return

A

The return that a portfolio actually earned

21
Q

How do you compute portfolio realized rate of return?

A

Sum of [weight (by value) times realized return] for each company

22
Q

Perfectly Positive Correlated Stocks

A

No diversificatoin

23
Q

Perfectly Negative Correlated Stocks

A

Risk is canceled out, ideal diversification

24
Q

Why is diversification important in investors?

A

Diversification reduces risk so when you want to pull out your money, there is a higher chance that you will most if not all your money that you invested.

25
Q

What are the two components of risk?

A

Systematic and unsystematic riks

26
Q

Systematic Risk

A

Market risk, volatility of the entire securities market

27
Q

What component of risk are we able to reduce the effects of?

A

Unsystmatic or firm-specific risk with diversification of a portfolio

28
Q

Unsystematic Risk

A

Firm-specific risk, volatility of the securities of a specific firm

29
Q

How many securities must be in a portfolio to eliminate unsystematic risk?

A

The law of diminishing returns dictates that you must have more than 40

30
Q

Market Portfolio

A

A portfolio of all the stocks in a particular market

31
Q

What does the standard deviation of the market portfolio represent?

A

The volatility of the entire system, the amount of systmatic risk of that particular market

32
Q

Capital Asset Price Model (CAPM)

A

A theory that quantifies the market risk of a stock by comparing the behavior of that stock to the behavior of the market portfolio, expressed with beta

33
Q

Beta

A

A measurement of the extent to which the returns of a particular security move with respect to the returns of the securities market at a whole

34
Q

What is the beta of the market portfolio?

A

1

35
Q

What does it mean if a stock has beta = 1?

A

It’s returns wil tend to move in the same direction and magnitude as the market portfolio; the stock is just as risky as the market

36
Q

What does it mean if a stock has beta = 2?

A

It’s returns will tend to move in the same direction but twice the magnitude as the market portfolio; the stock is twice as risky as the market

37
Q

What does it mean if a stock has beta = -1?

A

It’s returns will tend to move the same magnitude but in the opposite direction as the market portfolio; the stock has opposite risk

38
Q

What does it mean if a stock has beta = 0?

A

The direction and magnitude of it’s returns movements will be totally unrelated to the market portfolio

39
Q

How do you calculate beta?

A

Plot the stock’s historical returns against historical returns of the market portfolio and use regress to form a line; beta is the slope of the line

40
Q

What component of risk does beta quantify?

A

Market Risk or systematic risk

41
Q

How do you compute market risk premium?

A

Current average return for the market - nominal risk free rate

42
Q

How do you compute individual stock risk premium?

A

Market risk premium * beta of individual stock

43
Q

How do you calculate required ROR for an individual stock?

A

Nominal risk free rate + individual stock risk premium

44
Q

Why is it that required ROR calculated using the CAPM formula is different when calculated using statistical averaging of historical returns?

A

CAPM incoropates market risk only while statistical incorporates both componets of risk

45
Q

How do you calculate the beta of a portfolio?

A

Sum of (weight * individual stock beta) for each stock

46
Q

How do you calculate required ROR for a portfolio?

A

Nominal risk free rate + market risk premium * beta of portfolio

Mgmt 326 (4 decks)

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