Chapter 12

Question 1

What is systematic risk?

Answer 1

Market risk. Refers to the portion of a portfolio’s risk that is related to fluctuations in the overall market.

Question 2

What is unsystematic risk?

Answer 2

Non-market risk. Refers to the portion of the portfolio’s risk that is not related to fluctuations in the market.

Question 3

How is Beta calculated, by using?

Answer 3

Simple regression analysis. It plots the historical date of two variables to determine the linear relationship between them.

Question 4

What are the independent and dependent variables regarding?

Answer 4

Beta indicates how a change in the stock market (the independent variable) will impact an individual stock or portfolio (the dependent variable).

Question 5

What does semi-deviation measure?

Answer 5

It measures the downside risk of an investment. Only the returns below the average return are included in the equation.

Question 6

Define correlation of 0.

Answer 6

The security and market return are not related at all.

Question 7

Define positive correlation (between 0 and +1).

Answer 7

If one stock has a positive return, the other will usually have a positive return.
If one stock has a negative return the other will usually have a negative return.

Question 8

Define negative correlation (between 0 and -1).

Answer 8

If one stock has a positive return, the other one will usually have a negative return.
If one stock has a negative return, the other will usually have a positive return.

Question 9

Define correlation of exactly +1.

Answer 9

Also referred to as ‘perfectly positively correlated.
When one stock goes up, the other stock goes up in perfectly linear fashion.
When one stock goes down the other stock goes down in perfectly linear fashion.

Question 10

Define correlation of exactly -1.

Answer 10

Also referred to as ‘perfectly negatively correlated.
When one stock goes up, the other stock goes down in a perfectly linear fashion.
When one stock goes down, the other stock goes up in a perfectly linear fashion.

Question 11

What does ultimately diversified mean?

Answer 11

Occurs when two securities are perfectly negatively correlated (a correlation of -1), but doesn’t mean the move by the same dollar amount, it means that they always move in the opposite directions in the same ratio.

Question 12

What is the formula for time value?

Answer 12

Time value = market value of option - intrinsic value.

Question 13

Derivatives that trade on an exchange have the following characteristics:

Answer 13

1. Contract terms are standardized.
2. There is virtually no risk of default.
3. Standardization makes it possible to offset a contract and close out a position.

Question 14

Derivatives that trade over the counter (OTC) have the following characteristics:

Answer 14

1. Contracts can be customized.
2. There is a risk of default.
3. They are primarily dominated by large financial institutions, institutional investors and large corporations.

Question 15

Index stock options are similar to individual stock options with three notable differences:

Answer 15

1. Index stock options are almost always European style (can be exercised only at expiry).
2. Index options rarely provide perfect hedges. The portfolio and index return will rarely mirror each other exactly.
3. Index options are cash-settled.
   = Intrinsic value of the option x A multiplier (usually $100) x Number of contracts.

Question 16

When an investor purchases ‘index protective put options’ they are buying insurance against the overall market declining in value. The basic premise is as follows:

Answer 16

1. The investor owns equities.
2. The investor believes the overall equity market will decline.
3. Therefore, his or her equities will also decline (systematic risk).
4. Purchasing protection against the overall market declining will in turn protect the investor’s portfolio (to varying degrees depending on the option selected)

Question 17

A collar can be summarized by the following two points:

Answer 17

1. The investor wants to reduce the downside risk of an equity position.
2. In lieu of paying up-front dollars for the cost of the protection, the investor is willing to forgo some of the stock’s potential upside.

Question 18

What is the risk-reward ratio?

Answer 18

Risk-reward ratio = maximum risk / maximum gain

Question 19

What does LEAPS stand for and what are they?

Answer 19

Long-term equity anticipation securities.

They have an expiration date that is years away as opposed to traditional options that have maximum term of nine months.

Question 20

How is the premium on a short call taxed on LEAPS?

Answer 20

The premium received in from a short call is considered an immediate capital gain.

Question 21

How is a collar constructed?

Answer 21

By buying an out-of-the-money put and writing an out-of-the-money call.

Question 22

What is naive diversification?

Answer 22

Choosing securities randomly without regard to their particular risk and return characteristics.