Chapter 10 - Measuring Systematic Risk

Question 1

Probability distribution

Answer 1

assigns a probability (Pr) that each possible return (R) will occur

Question 2

Expected (or Mean) return

Answer 2

a weighted average of the possible returns, where the weights correspond to the probabilities

Question 3

variance

Answer 3

expected squared deviation from the mean

Question 4

standard deviation

Answer 4

the square root of the variance

Question 5

Realized return

Answer 5

the return that actually occurs over a particular time period

Question 6

Average Annual Return (of an investment)

Answer 6

the average of the realized returns for each year

Question 7

Standard error

Answer 7

the standard deviation of the estimated value of the mean of the actual distribution around its true value

Question 8

Excess return

Answer 8

the difference between the average return for the investment and the average return for treasury bills

Question 9

Types of risks are:

Answer 9

common risk
independent risk
diversification

Question 10

common risk

Answer 10

are risks that are perfectly correlated

Question 11

independent risk

Answer 11

are risks that are independent of each other

Question 12

diversification

Answer 12

is the averaging out of independent risks in a large portfolio

Question 13

firm-specific risks are also called:

Answer 13

diversifiable or idiosyncratic risks

Question 14

firm-specific risks are

Answer 14

fluctuations of a stock’s return that are due to firm-specific news

Question 15

Systematic risks are also called:

Answer 15

undiversifiable or market risk

Question 16

Systematic risks are

Answer 16

fluctuations of a stock’s return that are due to market-wide news

Question 17

Efficient Portfolio

Answer 17

A portfolio that only contains systematic risk. Changes in the market value of this portfolio will correspond to systematic shocks to the economy.

Question 18

Market Portfolio

Answer 18

is a type of an Efficient Portfolio. a portfolio that contains all shares of all stocks and securities in the market

Question 19

The beta of a security is the

Answer 19

expected percentage change in its return given a 1% change in return of the market portfolio

Question 20

Market Risk Premium

Answer 20

the extra expected return that premium investors earn by holding market risks (an incentive for taking risks)

Question 21

Capital Asset Pricing Model (CAPM)

Answer 21

is the most frequently used model used to estimate the cost of capital

Question 22

firm-specific risks

Answer 22

a risk that affects a very small number of assets in a large portfolio

Question 23

True or False

systematic risks will affect all firms and will not be diversified

Answer 23

True

Question 24

How do you measure systematic risk of a stock?

Answer 24

by measuring the beta

Question 25

Interpreting the Beta

Answer 25

The beta of a security is the sensitivity of the security’s return to the return of the overall market; it measures the expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio.
-Beta risk is the basis for CAPM

Question 26

The return indicates the percentage increase…

Answer 26

In the value of an investment per dollar initially invested. Each possible return has a likkihood of occuring.

Question 27

Empirical Distribution

Answer 27

Plotting annual returns in a histogram. The height of the bar represents the number of years that the anjual returns were in each range indicated on the x-axis.

Question 28

If a risky investment has a beta of zero, what should its cost of capital be according to
the CAPM? How can you justify this?

Answer 28

It should equal the risk-free rate because it has no systematic risk.

Question 29

Cost of Capital

Answer 29

The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt.

Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC).

Question 30

Cost of Debt

Answer 30

Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this phrase refers to after-tax cost of debt, but it also refers to a company’s cost of debt before taking taxes into account.

Question 31

Do expected returns for individual stocks appear to increase with volatility?

Answer 31

No, there is no clear relationship between the volatility and return of individual stocks.
While the smallest stocks have a slightly higher average return, many stocks have higher
volatility and lower average returns than other stocks. And all stocks seem to have higher
risk and lower returns than would be predicted based on extrapolation of data for large
portfolios.

Question 32

How much beta of a firm is there when it moves independently on the market?

Answer 32

zero because if it is independent, then it has no systematic risk.