Chapter 12 Flashcards
What is the real risk free rate?
The risk free real rate is the return that would be required if there were no inflation and no risk.
It can be thought of as the bare minimum that must be generated by an investment in any circumstances.
What is the inflation premium?
The inflation premium is required because inflation erodes the purchasing power of money, and the investor must be compensated for that erosion in the return on his investment.
What is the risk premium?
The risk premium of an investment is defined as the rate of return of the investment in excess of the return of a risk free investment, such as the purchase of government T-bills.
Relationship between risk and return (Equity, Bonds and Cash Deposits):
Equity investments are generally felt to be risky, but offer the potential to deliver high returns if held long-term. Relative to other investments (such as bonds and money market investments), and depending on the type of company (newly created or more established), the risk/reward profile is categorized as medium to high.
Bonds are generally considered to be less risky than equities, but offer less potential for substantial returns. Indeed, for highly rated bonds like US treasury Bonds where the risk of default is low, investors can be virtually certain of the yield that their investment will deliver as long as they hold their bonds to maturity. If the bonds are sold before they reach maturity, there is a danger that their market value may be below the par value, bringing about a capital loss and the potential to adversely impact the investor’s yield.
Investments like cash deposits and ‘treasury bills are low risk, relatively secure and deliver income, but provide little scope for capital growth. While it is intuitively clear that higher risk must be accompanied by higher returns, it is not at all clear what the quantitative relationship should be.
What is systematic risk?
Market risk is the risk that all investments are subject to as a result of the overall economic and political environment – for example a political crisis or general recession will have a negative impact on all investments. This risk is also known as Systematic Risk or non – diversifiable.
What is unsystematic risk?
This investment specific risk can be diversified through holding a wide range of individual companies’ shares, because unexpected losses made on one investment are offset by unexpected gains on another. For a diversified portfolio of investments, where the investment specific risks have been removed, only the market risk will remain. The investment specifies risk is also known as the unsystematic risk or diversifiable risk.
What is diversification and how do we maximize its benefits?
Diversification enables investors to reduce or remove investment specific risk. By efficiently diversifying the investments held in an investor’s portfolio, the investor can minimize risk for a given target level of return.
Combining assets that are negatively correlated (i.e. tend to move in opposing directions) will maximize the benefits of diversification.
What is correlation?
The manner in which the return of one security is related to the return of other securities in the portfolio.
What is the measurement of correlation?
The measure used is the correlation coefficient, that will lie somewhere between – 1 and + 1.
A correlation coefficient of – 1 is perfect negative correlation,
and a correlation coefficient of +1 is perfect positive correlation.
How many stocks should we invest into to get the most benefits of diversification?
In practice it is found that by the time a portfolio includes approximately 30 stocks most of the benefits of diversification have been achieved. The risk that can be diversified away is called the unique risk, the specific risk or the non-systematic risk. That risk that cannot be diversified away is called market risk or systematic risk.
What does CAPM calculate?
The Capital Asset Pricing Model (CAPM) quantifies the expected return on a security, based on an equation and assuming investors will only be rewarded for systematic risks, and not non-systematic or unique risk.
The systematic risk of a security is measured by its beta and can be loosely defined as the degree of dependence of the security’s return to the overall market.
What is the beta of a risk free investment?
It will have a beta value of 0.
What beta will security which is riskier than the overall stock market?
It will be greater than 1.
What beta will a security which is as risky as the overall stock market be?
1
1 - Which of the following is false?
(a) The expected return of a portfolio is always the weighted average of the expected return
of each asset in the portfolio.
(b) Covariance measures the co-movement between the returns of individual securities.
(c) The standard deviation of a portfolio is always the weighted average of the standard
deviations of individual assets in the portfolio.
(d) Standard deviation is easier to interpret than variance as a measure of risk.
(c) The standard deviation of a portfolio is always the weighted average of the standard deviations of individual assets in the portfolio.
