chapter 12 - Risk, Return and Capital Budgeting

Question 1

market portfolio def

Answer 1

portfolio of all assets in the economy

• in practice a broad stock market index such as the TSX or S&P 500
• used as a benchmark to measure risk of individual stocks

Question 2

beta def

Answer 2

• sensitivity of a stock’s return to the return on the market portfolio
• beta is a measure of market risk

Question 3

measuring market risk

Answer 3

• agressive stocks: high betas (>1)
• defensive stocks: low betas <1
• average is 1

Question 4

portfolio beta

Answer 4

• the portfolio beta is the weighted average of the betas of the individual assets
• weights are equal to the proportion of wealth invested in each asset

Question 5

market risk premium def
(MRP)

Answer 5

the risk premium of the market portfolio.
Expected extra return on the market portfolio relative to the return on risk-free Treasury Bills

Question 6

benchmark betas

Answer 6

• t-bill return is fixed and unaffected by what happens in the market so the beta of risk-free asset is 0
• beta of the market portfolio is 1
• we can calculate from this and the market risk premium the expected return on any asset

Question 7

Capital Asset Pricing Model (CAPM)

Answer 7

theory of the relationship between risk and return that states that the expected risk premium on any security equals its beta times the market risk premium

Question 8

security market line def

Answer 8

the graph showing the relationship between the market risk of the security and its expected return

• according to CAPM, expected rates of return for all securities and all portfolios lie on the SML

Question 9

how well does CAPM work?

Answer 9

• too simple to capture exactly how the stock markets work
• CAPM captures 2 fundamental financial principal: investors require extra return for taking on risk, investors are primarily concerned with the market risk they can’t eliminate by diversification

Question 10

company risk

Answer 10

the company cost of capital is the expected rate of return demanded by investors in a company determined by the average risk of the company’s assets and operations

Question 11

project risk

Answer 11

the project cost of capital depends on the use to which the capital is being put. Depends on the risk of the project and not the risk of the company