Chapter 10

Question 1

Systematic Risk

Answer 1

The risk that is common to all the securities in the market. This risk results in fluctuations of a stock’s returns that are due to market-wide news. It cannot be eliminated through diversification.

Question 2

Idiosyncratic Risk

Answer 2

Risks that are specific to one firm, and are independent risks across stocks. Examples would be bad management, lawsuits, defective products, etc. An investor can eliminate his or her exposure to idiosyncratic risks through diversification.

Question 3

Diversification

Answer 3

Process of balance risk against potential returns. This reduces the standard deviation.

Question 4

Equity Risk Premium

Answer 4

Additional expected return of the market portfolio above the risk-free rate. Equity risk premium = Expected return of the market – Risk free rate.

Question 5

Capital Asset Pricing Model (CAPM)

Answer 5

Financial model that calculates the expected rate of return for an asset or investment

Question 6

Beta

Answer 6

Measure of the sensitivity of a stock’s excess return to the excess return of the overall market. Specifically, Beta is the expected percent change of the security for a 1% change in the excess return of a market portfolio. There is no specific relationship between Beta and a stock’s total volatility.

Question 7

Under the Capital Asset Pricing Model (CAPM), what is the expected return of an investment in the stock of a corporation?

Answer 7

The expected return of a stock equals the risk-free rate plus Beta times the equity risk premium. Stock can be ranked in a linear fashion according to risk and return. Starting at the risk-free rate a straight line through the market portfolio (Beta equals 1) can be drawn and the expected return of all the stocks should fall on this line according to their particular beta. This graphical representation of the above formula is called the Security Market Line.

Question 8

Is the expected return the same for all stocks with the same total risk, as measured by the total volatility of their historical returns? Why or why not?

Answer 8

No, because investors do not get compensated for firm-specific risk because it can be eliminated through diversification. Investors only get compensated (in the form of higher expected returns) for systematic risk (also known as equity risk) as measured by Beta. So, firms with the same systematic risk have the same systematic return, even if their total volatility is much different. On the other hand, firms with the same total volatility may have much different expected returns, because the beta’s of those firms may be much different.