Chapter 14

Question 1

Realized return: (1)

Answer 1

-Realized return is what was actually earned during the period, it can be positive, zero or negative.

Question 2

Modern Portfolio Theory: (1)

Answer 2

• Investor has given sum of money to invest for a particular holding period
• At t=0 the investor must decide what securities to purchase and hold to t=1
• Portfolio selection problem: to select an optimal portfolio from the set of possible portfolios

Question 3

Optimal Portfolio: (2)

Answer 3

• Goal of maximizing return

- Goal of minimizing risk

Question 4

Risk Tolerance of individuals: (2)

Answer 4

• Risk Neutral

- Risk Adverse

Question 5

Risk Neutral: (1)

Answer 5

-Individuals or entities that make decisions based on expected return alone

Question 6

Risk Adverse: (1)

Answer 6

-Individuals or entities that consider a trade off between risk and return in making decisions

Question 7

Non Satiation and Risk Aversion: (3)

Answer 7

• Investor always prefer higher levels of terminal wealth to lower levels of terminal wealth.
• Assumed that investors are risk-averse
• Not assumed that investors have identical degrees of risk aversion

Question 8

Investment risk: (2)

Answer 8

• Investment risk pertains to the probability of realized returns being less than expected return.
• Greater the chance of low or negative returns, the riskier the investment.

Question 9

Risk Factors: (5)

Answer 9

• Default risk
• Interest rate risk
• Liquidity risk
• Reinvestment risk
• Inflation risk

Question 10

Why is the T-Bill return independent of the economy?: (1)

Answer 10

-It will return the promised 5% regardless of economy.

Question 11

Do T-Bills promise a completely risk free return?: (1)

Answer 11

No, T-bills are still exposed to risk of inflation. However not much unexpected inflation is likely to occur over a relatively short period.

Question 12

Stand-alone risk: (3)

Answer 12

• contains diversifiable company specific risk
• contains non-diversifiable market risk
• measured by dispersion of returns about the mean and is relevant only for assets held in isolation.

Question 13

Diversifiable risk?: (2)

Answer 13

• Caused by company specific events. ex. lawsuits, winning or losing major contracts
• effects of such events on a portfolio can be eliminated by diversification

Question 14

Market risk: (3)

Answer 14

• From external events as war, inflation, recession and interest rates.
• Firms are affected simultaneously by these factors, market risk can’t be eliminated by diversification.
• Market risk also known as systematic risk since it shows degree to which a stock moves systematically with other stocks.

Question 15

Portfolio expected return: (2)

Answer 15

• Contribution of each security to portfolio’s expected return depends only on expected return and proportionate share of the initial portfolio market value.
• investor who wants greatest expected return only should hold the one security with highest return.

Question 16

Beta: (1)

Answer 16

• Stocks with beta greater than 1.0 are known as aggressive stocks
• Stocks with beta less than 1.0 are known as defensive stocks

Question 17

Diversification: (1)

Answer 17

-Total risk of any security measured by its variance consists of two parts: Market/systematic risk and unique/unsystematic risk.

Question 18

Portfolio Risk: (1)

Answer 18

-total risk of any portfolio is measured by its variance and consists of two parts: market risk and unique risk

Question 19

Portfolio ‘Market’ risk: (2)

Answer 19

• Portfolio beta is an average of the beta of its securities

- unless an attempt is made, diversification will not cause the portfolio beta to change in a particular direction.

Question 20

What would have to the riskiness of a 1 stock portfolio as more randomly selected stocks were added?

Answer 20

-Standard deviation of portfolio would decrease because added stocks would not be perfectly correlated.

Question 21

If you chose to hold a one-stock portfolio, thus exposed to more risk than diversified investors, would you be compensated for all risk you bear?: (4)

Answer 21

• No, if you hold only one stock, you will not be compensated for additional risk you bear.
• stand alone risk (measured by st. dev) is not as important to a well-diversified investor.
• Rational risk averse investors are concerned with st. dev. or portfolio, based on market risk.
• Can only be one price, thus market return for a given security. Thus no compensation can be earned for additional risk of one-stock portfolio.

Question 22

Three forms of market efficiency: (3)

Answer 22

• Weak form: past prices
• Semi strong form: Publicly available info
• Strong form: all info, public and private.

Question 23

What should investor do in efficient market: (4)

Answer 23

• determine desired risk-return mix
• Diversify within type of investment, across types of investments, internationally
• Reduce costs to use a buy and hold strategy, trade less, use a discount broker
• Minimize taxes by sheltered investments, capital gains, dividends and interest.

Question 24

Time diversification: (2)

Answer 24

• Holding risker assets over long time period will almost certainly return more than a less risky portfolio.
• Invest in equity during early and middle stages of life cycle.

Question 25

Expected return: (1)

Answer 25

-Expected return is what is expected to happen in the future