chapter 11_ Introduction to risk, return and opportunity cost of capital

Question 1

rate of return formula

Answer 1

bonds: (coupon income + price change)/investment

stocks: (dividend income + price change)/ investment

Question 2

market index def

Answer 2

a measure of the investment performance of the overall market

Question 3

Canadian market index: S&P/TSX Composite index def

Answer 3

Index of the investment performance of a portfolio of the major stocks listed on the Toronto Stock Exchange

Question 4

US market index: Dow Jones Industrial Average def

Answer 4

Value of a portfolio that holds one share in each of 30 large (blue chip) firm

Question 5

US market index: Standard & Poor’s Composite Index def

Answer 5

Index of the investment performance of a portfolio of 500 large stocks

Question 6

Using historical evidence to estimate market return

Answer 6

• shows that investors have received a risk premium for holding risky assets
• expected market return = interest rate on Treasury bills + market risk premium

Question 7

measuring risk

Answer 7

• volatility of returns is what is considered as risk
• measured by: variance, standard deviation

Question 8

risk-return trade-off

Answer 8

• t-bills have the lowest average rate of return and lowest volatility
• stocks have the highest average rate of return and the highest level of volatility
• bonds are in the middle

Question 9

diversification def

Answer 9

strategy designed to reduce risk by spreading the portfolio across many investments

Question 10

2 kinds of assets risk

Answer 10

• unique risk
• market risk

total = unique + market

Question 11

unique risk def

Answer 11

• risk factors affecting only that firm
• also called specific, diversifiable or non-systematic risk

Question 12

market risk def

Answer 12

• economy-wide (macroeconomic) sources of risk that affect the overall stock market
• also called systematic or non-diversifiable risk

Question 13

asset vs portfolio risk

Answer 13

• instead of individual assets, we could construct a portfolio of two or multiple assets
• portfolio return is: fraction of portfolio 1st asset * rate of return + ….

Question 14

Why does diversification work

Answer 14

• reduces risk because the asset in the portfolio do not move in exact harmony with each other
  (when one stock does poorly, the other is doing well)
• reduction in rsik depends on the correlation coeff between assets

Question 15

correlation coeff

Answer 15

> 0: positive correlation => move in the same direction

<0: negative correlation +> variables move in opposite direction

=0: no correlation

Question 16

how to decrease the risk ?

Answer 16

• invest in two stock with correlation coeff less than 1 (less risk than holding each of them by themselves)
• adding stocks to the portfolio

Question 17

how much risk can you eliminate?

Answer 17

• not all of it
• over 15 stocks, adding more reduces the risk by very little
• risk that can’t be diversified away is called the market risk

Question 18

risk facts

Answer 18

• some risk are diverisifable
• market risks are macro risks : uncertain events affecting the entiere securities market and economy
• risk can be measured