CH7 Flashcards
What is risk in finance?
The chance of investment returns being different from expected returns.
What is return?
The gain or loss from an investment over time.
How is total return calculated?
R = (D + (P1 - P0)) / P0
What is systematic risk?
Risk that affects all investments (e.g., inflation, recessions).
What is unsystematic risk?
Risk specific to a company or industry (e.g., bad management, lawsuits).
What is the expected return formula?
E(R) = p1R1 + p2R2 + … + pnRn
What does standard deviation measure in investing?
How much actual returns vary from expected returns.
How does diversification affect risk?
It reduces unsystematic risk but not systematic risk.
What is the Capital Asset Pricing Model (CAPM) formula?
E(Ri) = Rf + β(E(Rm) - Rf)
What does β (beta) measure?
A stock’s volatility compared to the market.
What does it mean if a stock has a beta of 1.5?
It is 50% more volatile than the market.
What is the risk-free rate?
The return on an investment with no risk (e.g., government bonds).
What is the market risk premium?
The difference between the expected market return and the risk-free rate.
What is the Security Market Line (SML)?
A graph showing the relationship between expected return and risk (beta).
How do you calculate a portfolio’s expected return?
E(Rp) = w1E(R1) + w2E(R2) + … + wnE(Rn)
What is portfolio beta?
The weighted average of the betas of assets in a portfolio.
What happens to the SML when inflation increases?
It shifts up, increasing required returns for all investments.
What is the efficient frontier?
A set of optimal portfolios offering the highest return for a given level of risk.
Why does diversification reduce risk?
It spreads investments, reducing unsystematic risk.
What is the relationship between risk and return?
Higher risk = Higher potential return.
How does CAPM determine expected return?
By using the risk-free rate, beta, and market return.
What happens to required returns when risk aversion increases?
The market risk premium increases.
What does a stock’s Sharpe Ratio measure?
How much excess return it generates per unit of risk.
What is the difference between value and growth stocks?
Value stocks are undervalued; growth stocks are expensive but expected to grow fast.
What happens to stock prices when interest rates rise?
Stock prices usually fall because bond yields become more attractive.
What type of risk can be eliminated through diversification?
Unsystematic risk (company-specific risk).
How does a diversified portfolio reduce risk?
It offsets losses in one stock with gains in another.
Why does beta matter in portfolio management?
It determines how risky a portfolio is compared to the market.
