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.
