Chap.2_Basic models of risk in finance Flashcards
What is the one-period return of a single stock?
Using one-period returns on several periods, how can you compute the return of one stock over several periods?
What is the arithmetic/geometric average of returns (mathematically)?
What is the difference between arithmetic and geometric average?
- Geometric average takes into account the compounded interests.
- Arithmetic average ignores this connection and considers an average of the returns taken independently.
When do use arithmetic vs. geometric average?
- We use geometric average to compute an average historical return.
- We use arithmetic average to compute an expected (future) return, estimated based on past observed returns.
How is risk implied by returns?
Risk is implied by the uncertainty of the return distribution.
What are the characteristics of return distributions? Define them briefly.
In the context of stock returns, how is risk measured mathematically?
By the standard deviation of returns.
What is risk (mathematically)?
Mathematically, risk is how much observed returns deviate from the expected return (i.e. from the
arithmetic average return).
What are the advantages of the standard deviation as a measure of risk? Its limitations?
A. Advantages of standard deviation:
1. Easy to calculate and implement
2. Takes into account both upside and downside risk
B. Drawbacks of standard deviation:
1. Investors are usually worried about the downside risk only (i.e. the risk of loss).
2. SD includes both the upside risk and the downside risk. If returns are skewed it is not the only relevant measure of risk
What is the return of a two-asset portfolio?
What is the return of a n-asset portfolio?
What is the risk of a two-asset portfolio?
What is the correlation between the returns of two assets (in English)?
The correlation between the returns of two assets is how their returns move together.
What are the possible values of return correlation? Explain briefly what they correspond to.
What is the relationship between the risk of a portfolio and the correlation of its assets?
The relationship is that the risk (standard deviation of a portfolio) is less than the weighted sum of the risks of each of its assets.
How could you reduce your portfolio risk? Explain briefly.
- To reduce a portfolio risk you must find assets that are less correlated. The risk of a portfolio decreases when the correlation between its assets decreases.
In a portfolio that has two assets that are perfectly negatively correlated (correlation = - 1), when one increases the other decreases in the exact same amount. The portfolio is thus protected (i.e. bears less risk). - To reduce your portfolio risk you should diversify as much as you can. Generally the more assets you add in your portfolio, the lower your portfolio risk. This phenomenon is called diversification.
What does the CAPM model try to model?
- What is the theoretical return of a given asset required by investors for them to buy it.
- What is the fair return an investor should obtain when investing in this asset.
What are the assumptions of the CAPM model?
According to the CAPM model, how the return of an asset is measured?
What is the beta of an asset? How should you interpret it?
The beta is a measure of systematic risk. It measures by how much an individual security covary with the market.
How do you measure total risk? How do you measure systematic risk?
What are the implications of market efficiency?
- If markets are indeed efficient, value is just more risky (Fama-French three-factor model).
- If markets are not efficient, investors’ errors create the value premium (behavioral finance).
Why does not market efficiency actually work?
- The beta does not explain alone average security returns.
- The combination of size and book to market ratios does explain average
security returns.
Why does the competitive markets hypothesis of the CAPM not work? (The assumption: Markets are perfectly competitive all agents borrow lend at the same rate, buy sell any asset at the same price with no taxes and no transaction costs.)
- Companies, financial institutions, wealthy investors tend to borrow at a cheaper rate.
- There are taxes: corporate taxes, income taxes.
What is the equity premium puzzle?
Average US equity returns (S&P 500) have been about twice as large as those of long-term Treasuries over the last 100 years.
Which contribution (or addition) does the Fama-French three-factor model make to the CAPM model?
According to the Fama-French three-factor model:
1. The beta does not explain alone average security returns
2. The combination of size and book-to-market ratios does explain average security returns.
Thus, the contributions are:
1. Size.
2. Book-to-market ratio.
According to the Fama-French three-factor model, how is the return of an asset measured (mathematically)?
Explain the three factors in the Fama-French three-factor model.
- Beta or risk.
- 𝑆𝑀𝐵𝑡 (“Small Minus Big”) is the return of a portfolio of small stocks minus the return of a portfolio of large stocks.
- 𝐻𝑀𝐿𝑡 (“High Minus Low”) is the return of a portfolio of value stocks (with a high book-to-market ratio) minus the return of a portfolio of growth stocks (with a low book-to-market ratio).
Which theories can explain the fact that the CAPM model is not empirically verified?
1 The Ferma-French three-factor model.
2. Behavioral finance: prospect theory.
Define behavioral finance.
A field that studies the impact of emotion, cognitive biases, and other psychological factors on financial decision making and hence on financial markets (APA Dictionary of Psychology).
What is the main contribution of behavioral finance to traditional portfolio theory?
Not all investors are rational; therefore there are systematic cognitive and heuristic biases in people.
Cite and define five well-known (behavioral) biases in finance.
- Loss aversion
- Overconfidence
- Overoptimism
- Misjudgements of probabilities and laws of probabilities
- Herding
