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Business Finance > Chapter 13 Return, risk, and the security market line > Flashcards

Chapter 13 Return, risk, and the security market line Flashcards

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1
Q

reward for bearing risk

A

risk premium

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2
Q

2 types of risk

A
  1. systematic
  2. unsystematic
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3
Q

highly diversified portfolios will tend to have no unsystematic risk

A

principle of diversification

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4
Q

the relationship between risk and return is shown

A

security market line (SML)

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5
Q

scenarios with particular probabilites

A

states of the economy

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6
Q

the return on a risky asset expected in the future

A

Expected return
(the expected return on a security is equal to the sum of the possible return multiplied by their responsibilities)

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7
Q

the difference between the return on a risky investment and the return on a risk free investment

A

Risk premium

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8
Q

How to determine the variance of returns on securities in 3 ways

A
  1. Determine the squared deviations from the expected return
  2. Multiply each possible squared deviation by its probability
  3. Sum the products of step 2
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9
Q

a group of assets such as stocks and bonds held by an investor

A

Portfolio

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10
Q

the percentage of a portfolios total value that is invested in a particular asset

A

Portfolio weight
(The expected return on a portfolio is the weighted average of the expected return of the assets in the portfolio)

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11
Q

The expected return on a portfolio is the weighted average of the expected return of the assets in the portfolio

A

substantially alter the risks faced by the investor

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12
Q

Portfolios increase diversification, thereby _____ risk

A

decreasing

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13
Q

The return on any stock traded in a financial market is composed of 2 parts

A
  1. Expected return: predicted by the market
  2. Unexpected return: comes from unexpected information revealed
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14
Q

In the long run the average value of unexpected returns will be zero, so on average the actual return equals

A

the expected return

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15
Q

a discounted announcement has less of an impact on the price because the market already knew much of it

A

Price in

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16
Q

a difference between the actual result and the forecast

A

Innovation/Surprise

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17
Q

Expected part of the anouncement formula is used by the market to form

A

expectations

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18
Q

Surprise in the anouncement formula influences the

A

unexpected return

19
Q

a risk that influences a larger number of assets

A

Systematic risk/market risk
(Examples: GDP, interest rates, inflation)

20
Q

All firms are susceptible to this

A

systematic risk

21
Q

a risk that affects at most a small number of assets

A

Unsystematic risk/unique or asset specific risk
(Examples: pharmaceutical research breakthrough, oil strike)

22
Q

the process of spreading an investment across assets (and thereby forming a portfolio

A

Diversification

23
Q

spreading an investment across a number of assets will eliminate some, but not all, of the risk

A

Principle of diversification

24
Q

2 key points of principles of diversification

A
  1. Some of the riskiness associated with individual assets can be eliminated by forming portfolios
  2. There is a minimum level of risk that cannot be eliminated by diversifying (nondiversifiable risk)
25
Q

________ risk tends to wash out when assets are combine into portfolios, once there are more than just a few assets

A

unsystematic risk

26
Q

Unsystematic risk is essentially eliminated by

A

diversification
(so a portfolio with many assets has almost no unsystematic risk)

27
Q

______ risk cannot be eliminated by diversification

A

systematic

28
Q

Also call non-diversifiable

A

systematic risk

29
Q

the expected return on a risky asset depends only on that assets systematic risk

A

Systematic risk principle

30
Q

No reward for bearing ________ risk because it can be eliminated at virtually no cost (by diversification)

A

unsystematic risk

31
Q

the amount of systematic risk present in a particular risky asset relative to that in an average asset

A

Beta coefficient

32
Q

An average asset has a beta of

A

1.0

33
Q

The beta of the market is

A

1.0

34
Q

Because assets with larger betas have greater systematic risks, they will have _______ expected returns

A

greater

35
Q

The reward to risk ratio must be

A

the same for all the assets in the market

36
Q

a positively sloped straight line displaying the relationship between expected return and beta

A

Security market line (SML)

37
Q

Describes the relationship between systematic risk and expected return in financial markets

A

Security market line (SML)

38
Q

the slop of the SML: which is the difference between the expected return on a market portfolio and the risk free rate

A

Market risk premium

39
Q

the equation of the SML showing the relationship between expected return and beta

A

Capital asset pricing model (CAPM)

40
Q

The CAPM shows that the expected return for a particular asset depends on 3 things

A
  1. The pure time value of money: as measure by the risk free rate, Rꜜf this is the reward for merely waiting for your money, without taking any risk
  2. The reward for bearing systematic risk: as measured by the market risk premium, E (Rꜜm) - Rꜜf , this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting
  3. The amount of systematic risk: as measured by bet, βi, this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset
41
Q

the excess return as asset earns based on the level of risk taken

A

Alpha

42
Q

The distance between actual return and the SML

A

alpha

43
Q

an asset or portfolio has earned a return greater than what should have been earned based on its beta

A

Positive alpha

44
Q

an asset or portfolio has earned a return less than what should have been earned based on its beta

A

Negative alpha

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