Chap11 Return and Risk Flashcards
What is variance?
A measure of the squared deviations of a security’s return from its expected return
What is true about variance?
- Standard deviation is the square root of variance
- variance is a measure of the squared deviations of a security’s return from its expected return
What is true about correlation
- Correlation measures the interrelationship between the returns of two securities
- Correlation is related to covariance
What do covariance and correlation measure
They both measure how two random variables are related
Which one of the following cannot possibly be the correlation coefficient between the returns of two stocks
0
1
1.2
-.98
What is true if we observe the returns of two stocks in the same industry, such as Pfizer and Merck
- the returns will be positively correlated over time
- the returns will move in the same direction (i.e. positive) but not by the same magnitude
What can we conclude if the covariance between the returns of two securities is zero?
-the returns of the two securities are unrelated
Two ways to measure the relationship between the returns of securities are ___ and ___.
Covariance and Correlation
What are the correlation coefficient’s lowest and highest possible values?
-1 and +1
What does it mean if the returns of two stocks, A and B, are negatively correlated?
It means that, on average, if the returns of stock A are positive, the returns of stock B will be negative.
What is the covariance for two securities with returns that are unrelated to each other?
Zero
The computation of variance requires 4 steps.
- Calculate the expected return
- Calculate the deviation of each return from the expected return
- Square each deviation
- Calculate the average squared deviation
Examples of a portfolio
- Investing $100,000 in a combination of stocks and bonds
- Investing $100,000 in the stocks of 50 publicly traded corporations
- Investing $100,000 in a combination of US and Asian stocks
Generally thought of as a risk-free security…
3-month treasury bill
Investors cannot attain a portfolio below the feasible set or opportunity set because they cannot______.
- increase the standard deviation of the securities
- lower the return on individual securities
- increase the correlation between two securities
Examples of unsystematic risks faced by a firm…
- A hostile takeover attempt by a competitor
- The death of the CEO
Examples of systematic risk faced by a firm…
- Future rates of inflation
- Regulatory changes in tax rates
The diversification benefits from holding two securities in a portfolio are maximized when the correlation between the securities is____.
-1
What is the required minimum number of stocks if you wish to create a portfolio of stocks…
You must invest in stocks of more than one corporation.
Bull market
characterized by rising prices
Bear market
characterized by falling prices
What are the parts of an announcement
- Surprise
- Expected part
If the variance of a portfolio is .0025, what is the standard deviation?
.05 or 5%
What is the slope of the security market line (SML)?
The market-risk premium
A minimum variance portfolio will be characterized by its____.
- lowest possible standard deviation
- lowest possible variance
According to the CAPM, a security is considered underpriced when its expected return plots ____the SML.
above
What does the characteristic line for a security show?
- a security’s responsiveness to the movement in the market portfolio
- a security’s return in relation to the market’s return
___ risk is reduced as more securities are added to the portfolio.
- Unsystematic
- Unique
- Idiosyncratic
What is true about optimal portfolios?
- They offer the lowest risk for a given level of return
- they offer the highest return for a given level of risk
- they provide the best risk-return trade-off
What is needed in order to compute the variance of a portfolio consisting of two stocks, A and B?
- the variances of stocks A and B
- The covariance between stocks A and B
- The market value, in dollars, of the investments in stocks A and B
Risk aversion means that investors will not take risks. True/False
FALSE
In the context of a portfolio of two securities, the opportunity set___
shows the range of risk-return combinations, based on various weights for the two securities
Diversification is possible as long as the correlation between securities is___.
Less than +1
(as long as the securities within the portfolio are not perfectly positively correlated, some diversification benefit is realized.)
If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities?
1.25
In practice, economists use proxies for the market portfolio instead of the actual market portfolio. True/False
TRUE
What are the two components of the expected return on the market
- risk-free rate
- risk premium
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?
the risk-free rate of return
Examples of information that may impact the risky return of a stock
- The Fed’s decision on interest rates at their meeting next week
- The outcome of an application currently pending with the Food and Drug Administration.
What is correlation of returns between stocks A and B if…standard deviation of returns is .30 for A and .20 for B and the covariance between A and B’s returns is .045?
.045/(.3x.2)=.75
Reasons why an investor cannot attain a portfolio above the feasible or opportunity set
- investor cannot increase the return on individual securities
- investor cannot decrease the correlation between the two securities
- investor cannot decrease the standard deviation of individual securities
Which portfolio will an investor who is very risk averse select from the opportunity set of risky assets?
the portfolio with minimum variance or minimum standard deviation
What does the backward bending portion of the feasibility set indicate
A reduction in portfolio risk due to diversification benefits
Two-asset portfolio is in the efficient set of portfolio
- Portfolio A has a higher return and higher standard deviation than the minimum variance portfolio
- Portfolio D has a lower standard deviation and lower expected return than the minimum variance portfolio
If Portfolio P has a lower expected return but a higher standard deviation than the minimum variance portfolio, we say that Portfolio P is ___ by the minimum variance portfolio.
dominated
Combining a less risky US stock fund with a more risky Asian stock fund would reduce the overall risk of a portfolio if…
the correlation between the two markets was less than 1
Why have pension funds sought investment opportunities overseas?
to reduce risk
The efficient set depends on the…
- expected returns of individual securities
- variances of individual securities
- covariances between pairs of securities
Why is the determination of the efficient set for 50(many) securities more complex than the determination of the efficient set for two securities?
the number of variance, return, and correlation calculations increases dramatically
What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is NEGATIVE?
the variance will DECREASE
What is the standard deviation (SD) of a portfolio that includes a risk-free security and a risky security?
WEIGHTrisky x SDrisky
A minimum variance portfolio has the ___.
lowest possible variance
The efficient set is a subset of the feasible set. True/False
TRUE
What is a normal return?
it is the return that shareholders predict or expect.
What is systematic risk?
it is a risk that pertains to a large number of assets
What is unsystematic risk?
It is a risk that affects a single asset or a small group of assets.
There is ___ correlation between the unsystematic risk of two companies from different industries.
no
It is possible for the unsystematic risk of a portfolio to be reduced to practically zero. True/False
True
What is the main purpose of holding a diversified portfolio?
To reduce total risk by spreading investment dollars across various assets
When new securities are added to a 10-stock portfolio, the total unsystematic, or diversifiable risk portion of that portfolio will tend to ____.
decrease
Which type of risk is unaffected by adding securities to a portfolio?
systematic risk
systematic risk will ___ when securities are added to a portfolio.
not change
If investors have homogeneous expectations, they will ____.
have similar estimates about the risk and return attributes of individual securities
For a diversified investor, what is the best way to measure the systematic risk of an individual security?
Beta
The risk of a large, diversified portfolio will ____ if a security with a negative beta is added to the portfolio.
decrease
Beta measure ____ risk.
systematic
Beta measures the responsiveness of a security to movements in the market portfolio.
What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?
.6=1.5/2.5
The risk of an individual security depends on the security’s _____.
covariance with the market.
A security has a beta of 1, the market risk premium is 8 percent, and the risk-free rate is 3 percent. What will happen to the expected return if the beta doubles?
the expected return will increase to 19% from 11%
Based on the capital asset pricing model (CAPM) there is generally ____ relationship between beta and the expected return on a security.
a positive
The expected return on the market will increase if the risk-free rate ____ or if the market risk premium ____.
increases, increases
To attract investors who are ready to take risk, the risk premium for the stock market will be:
positive
The security market line (SML) shows that the relationship between a security’s expected return and its beta is _____.
positive
How can a positive relationship between expected return on a security and its beta be justified?
Because the difference between the return on the market and the risk-free rate is likely to be positive.
