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FINC515 > Chap11 Return and Risk > Flashcards

Chap11 Return and Risk Flashcards

1
Q

What is variance?

A

A measure of the squared deviations of a security’s return from its expected return

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2
Q

What is true about variance?

A
  • 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

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3
Q

What is true about correlation

A
  • Correlation measures the interrelationship between the returns of two securities
  • Correlation is related to covariance
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4
Q

What do covariance and correlation measure

A

They both measure how two random variables are related

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5
Q

Which one of the following cannot possibly be the correlation coefficient between the returns of two stocks

A

0
1
1.2
-.98

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6
Q

What is true if we observe the returns of two stocks in the same industry, such as Pfizer and Merck

A
  • 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

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7
Q

What can we conclude if the covariance between the returns of two securities is zero?

A

-the returns of the two securities are unrelated

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8
Q

Two ways to measure the relationship between the returns of securities are ___ and ___.

A

Covariance and Correlation

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9
Q

What are the correlation coefficient’s lowest and highest possible values?

A

-1 and +1

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10
Q

What does it mean if the returns of two stocks, A and B, are negatively correlated?

A

It means that, on average, if the returns of stock A are positive, the returns of stock B will be negative.

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11
Q

What is the covariance for two securities with returns that are unrelated to each other?

A

Zero

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12
Q

The computation of variance requires 4 steps.

A
  1. Calculate the expected return
  2. Calculate the deviation of each return from the expected return
  3. Square each deviation
  4. Calculate the average squared deviation
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13
Q

Examples of a portfolio

A
  • 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
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14
Q

Generally thought of as a risk-free security…

A

3-month treasury bill

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15
Q

Investors cannot attain a portfolio below the feasible set or opportunity set because they cannot______.

A
  • increase the standard deviation of the securities
  • lower the return on individual securities
  • increase the correlation between two securities
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16
Q

Examples of unsystematic risks faced by a firm…

A
  • A hostile takeover attempt by a competitor

- The death of the CEO

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17
Q

Examples of systematic risk faced by a firm…

A
  • Future rates of inflation

- Regulatory changes in tax rates

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18
Q

The diversification benefits from holding two securities in a portfolio are maximized when the correlation between the securities is____.

A

-1

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19
Q

What is the required minimum number of stocks if you wish to create a portfolio of stocks…

A

You must invest in stocks of more than one corporation.

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20
Q

Bull market

A

characterized by rising prices

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21
Q

Bear market

A

characterized by falling prices

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22
Q

What are the parts of an announcement

A
  • Surprise

- Expected part

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23
Q

If the variance of a portfolio is .0025, what is the standard deviation?

A

.05 or 5%

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24
Q

What is the slope of the security market line (SML)?

A

The market-risk premium

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25
Q

A minimum variance portfolio will be characterized by its____.

A
  • lowest possible standard deviation

- lowest possible variance

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26
Q

According to the CAPM, a security is considered underpriced when its expected return plots ____the SML.

A

above

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27
Q

What does the characteristic line for a security show?

A
  • a security’s responsiveness to the movement in the market portfolio
  • a security’s return in relation to the market’s return
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28
Q

___ risk is reduced as more securities are added to the portfolio.

A
  • Unsystematic
  • Unique
  • Idiosyncratic
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29
Q

What is true about optimal portfolios?

A
  • 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
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30
Q

What is needed in order to compute the variance of a portfolio consisting of two stocks, A and B?

A
  • 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
31
Q

Risk aversion means that investors will not take risks. True/False

A

FALSE

32
Q

In the context of a portfolio of two securities, the opportunity set___

A

shows the range of risk-return combinations, based on various weights for the two securities

33
Q

Diversification is possible as long as the correlation between securities is___.

A

Less than +1

(as long as the securities within the portfolio are not perfectly positively correlated, some diversification benefit is realized.)

34
Q

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?

A

1.25

35
Q

In practice, economists use proxies for the market portfolio instead of the actual market portfolio. True/False

A

TRUE

36
Q

What are the two components of the expected return on the market

A
  • risk-free rate

- risk premium

37
Q

According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?

A

the risk-free rate of return

38
Q

Examples of information that may impact the risky return of a stock

A
  • 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.
39
Q

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?

A

.045/(.3x.2)=.75

40
Q

Reasons why an investor cannot attain a portfolio above the feasible or opportunity set

A
  • 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
41
Q

Which portfolio will an investor who is very risk averse select from the opportunity set of risky assets?

A

the portfolio with minimum variance or minimum standard deviation

42
Q

What does the backward bending portion of the feasibility set indicate

A

A reduction in portfolio risk due to diversification benefits

43
Q

Two-asset portfolio is in the efficient set of portfolio

A
  • 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
44
Q

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.

A

dominated

45
Q

Combining a less risky US stock fund with a more risky Asian stock fund would reduce the overall risk of a portfolio if…

A

the correlation between the two markets was less than 1

46
Q

Why have pension funds sought investment opportunities overseas?

A

to reduce risk

47
Q

The efficient set depends on the…

A
  • expected returns of individual securities
  • variances of individual securities
  • covariances between pairs of securities
48
Q

Why is the determination of the efficient set for 50(many) securities more complex than the determination of the efficient set for two securities?

A

the number of variance, return, and correlation calculations increases dramatically

49
Q

What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is NEGATIVE?

A

the variance will DECREASE

50
Q

What is the standard deviation (SD) of a portfolio that includes a risk-free security and a risky security?

A

WEIGHTrisky x SDrisky

51
Q

A minimum variance portfolio has the ___.

A

lowest possible variance

52
Q

The efficient set is a subset of the feasible set. True/False

A

TRUE

53
Q

What is a normal return?

A

it is the return that shareholders predict or expect.

54
Q

What is systematic risk?

A

it is a risk that pertains to a large number of assets

55
Q

What is unsystematic risk?

A

It is a risk that affects a single asset or a small group of assets.

56
Q

There is ___ correlation between the unsystematic risk of two companies from different industries.

A

no

57
Q

It is possible for the unsystematic risk of a portfolio to be reduced to practically zero. True/False

A

True

58
Q

What is the main purpose of holding a diversified portfolio?

A

To reduce total risk by spreading investment dollars across various assets

59
Q

When new securities are added to a 10-stock portfolio, the total unsystematic, or diversifiable risk portion of that portfolio will tend to ____.

A

decrease

60
Q

Which type of risk is unaffected by adding securities to a portfolio?

A

systematic risk

61
Q

systematic risk will ___ when securities are added to a portfolio.

A

not change

62
Q

If investors have homogeneous expectations, they will ____.

A

have similar estimates about the risk and return attributes of individual securities

63
Q

For a diversified investor, what is the best way to measure the systematic risk of an individual security?

A

Beta

64
Q

The risk of a large, diversified portfolio will ____ if a security with a negative beta is added to the portfolio.

A

decrease

65
Q

Beta measure ____ risk.

A

systematic

Beta measures the responsiveness of a security to movements in the market portfolio.

66
Q

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?

A

.6=1.5/2.5

67
Q

The risk of an individual security depends on the security’s _____.

A

covariance with the market.

68
Q

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?

A

the expected return will increase to 19% from 11%

69
Q

Based on the capital asset pricing model (CAPM) there is generally ____ relationship between beta and the expected return on a security.

A

a positive

70
Q

The expected return on the market will increase if the risk-free rate ____ or if the market risk premium ____.

A

increases, increases

71
Q

To attract investors who are ready to take risk, the risk premium for the stock market will be:

A

positive

72
Q

The security market line (SML) shows that the relationship between a security’s expected return and its beta is _____.

A

positive

73
Q

How can a positive relationship between expected return on a security and its beta be justified?

A

Because the difference between the return on the market and the risk-free rate is likely to be positive.

FINC515 (6 decks)

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