Chapter 10 - Measuring Systematic Risk Flashcards
Probability distribution
assigns a probability (Pr) that each possible return (R) will occur
Expected (or Mean) return
a weighted average of the possible returns, where the weights correspond to the probabilities
variance
expected squared deviation from the mean
standard deviation
the square root of the variance
Realized return
the return that actually occurs over a particular time period
Average Annual Return (of an investment)
the average of the realized returns for each year
Standard error
the standard deviation of the estimated value of the mean of the actual distribution around its true value
Excess return
the difference between the average return for the investment and the average return for treasury bills
Types of risks are:
common risk
independent risk
diversification
common risk
are risks that are perfectly correlated
independent risk
are risks that are independent of each other
diversification
is the averaging out of independent risks in a large portfolio
firm-specific risks are also called:
diversifiable or idiosyncratic risks
firm-specific risks are
fluctuations of a stock’s return that are due to firm-specific news
Systematic risks are also called:
undiversifiable or market risk
Systematic risks are
fluctuations of a stock’s return that are due to market-wide news
Efficient Portfolio
A portfolio that only contains systematic risk. Changes in the market value of this portfolio will correspond to systematic shocks to the economy.
Market Portfolio
is a type of an Efficient Portfolio. a portfolio that contains all shares of all stocks and securities in the market
The beta of a security is the
expected percentage change in its return given a 1% change in return of the market portfolio
Market Risk Premium
the extra expected return that premium investors earn by holding market risks (an incentive for taking risks)
Capital Asset Pricing Model (CAPM)
is the most frequently used model used to estimate the cost of capital
firm-specific risks
a risk that affects a very small number of assets in a large portfolio
True or False
systematic risks will affect all firms and will not be diversified
True
How do you measure systematic risk of a stock?
by measuring the beta
Interpreting the Beta
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
The return indicates the percentage increase…
In the value of an investment per dollar initially invested. Each possible return has a likkihood of occuring.
Empirical Distribution
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.
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?
It should equal the risk-free rate because it has no systematic risk.
Cost of Capital
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).
Cost of Debt
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.
Do expected returns for individual stocks appear to increase with volatility?
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.
How much beta of a firm is there when it moves independently on the market?
zero because if it is independent, then it has no systematic risk.
