Ch 11/12: Risk and Return Flashcards
What is risk
The reliability of the rate of return
What is financial risk?
The chance that an outcome other than that which was desired will occur
What is uncertainty?
The lack of knowledge of what will happen in the future
Average Annual Return
The arithmetic average of an investment’s realized annual stock returns over a certain period
How do you compute average annual return?
1/TimeInYears(realized return of year one + realized return of year two….)
Average annual return is equal to
realized return
How many years of data do you use to compute average annual return?
The number of years in the future you wish to estimate
Standard deviation tells us what?
How reliable or risky it is
What does a high standard deviation mean?
Has a greater range of possible outcomes, more risky
What does a small standard deviation mean?
More reliable, less uncertainty due to narrower probability distribution
Risk Aversion
Given two securities with equal expected returns but different degrees of risk, the rational investor would choose the one with lower risk
Coefficient of Variation
A way to quantify the relationship between risk and return, shows the risk per unit of return, provides standardized measure of risk
Coefficient of variation is only useful for what?
Stocks in the same industry
How do you find the coefficient of variation?
Standard deviation/return%
When does CV not work?
When stocks are in different industry, or if expected returns are significantly different
Which is less risky: portfolio investing or single security investing?
Portfolio investing
Why is portfolio investing less risky?
The risks of the individual securities comprising the portfolio are averages
Diversification
The tendency for price movements of individual securities to counteract each other
What is the equation to find the expected return of a portfolio?
Sum of [weight (by value) times expected return] for each company
Portfolio Realized Rate of Return
The return that a portfolio actually earned
How do you compute portfolio realized rate of return?
Sum of [weight (by value) times realized return] for each company
Perfectly Positive Correlated Stocks
No diversificatoin
Perfectly Negative Correlated Stocks
Risk is canceled out, ideal diversification
Why is diversification important in investors?
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.
What are the two components of risk?
Systematic and unsystematic riks
Systematic Risk
Market risk, volatility of the entire securities market
What component of risk are we able to reduce the effects of?
Unsystmatic or firm-specific risk with diversification of a portfolio
Unsystematic Risk
Firm-specific risk, volatility of the securities of a specific firm
How many securities must be in a portfolio to eliminate unsystematic risk?
The law of diminishing returns dictates that you must have more than 40
Market Portfolio
A portfolio of all the stocks in a particular market
What does the standard deviation of the market portfolio represent?
The volatility of the entire system, the amount of systmatic risk of that particular market
Capital Asset Price Model (CAPM)
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
Beta
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
What is the beta of the market portfolio?
1
What does it mean if a stock has beta = 1?
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
What does it mean if a stock has beta = 2?
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
What does it mean if a stock has beta = -1?
It’s returns will tend to move the same magnitude but in the opposite direction as the market portfolio; the stock has opposite risk
What does it mean if a stock has beta = 0?
The direction and magnitude of it’s returns movements will be totally unrelated to the market portfolio
How do you calculate beta?
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
What component of risk does beta quantify?
Market Risk or systematic risk
How do you compute market risk premium?
Current average return for the market - nominal risk free rate
How do you compute individual stock risk premium?
Market risk premium * beta of individual stock
How do you calculate required ROR for an individual stock?
Nominal risk free rate + individual stock risk premium
Why is it that required ROR calculated using the CAPM formula is different when calculated using statistical averaging of historical returns?
CAPM incoropates market risk only while statistical incorporates both componets of risk
How do you calculate the beta of a portfolio?
Sum of (weight * individual stock beta) for each stock
How do you calculate required ROR for a portfolio?
Nominal risk free rate + market risk premium * beta of portfolio
