Chapter 2

Question 1

what do investors like and dislike

Answer 1

return and dislike risk

Question 2

what are investment returns

Answer 2

investment returns measure the financial performance of an investment

Question 3

what is investment risk

Answer 3

investment risk is exposure to the chance of earning less than expected

Question 4

how can an asset risk be analyzed

Answer 4

1. on a standalone basis (considered in isolation)
2. Portfolio basis (the asset is held as one of a number of assets)

Question 5

what is expected rate of return

Answer 5

the weighted average of the possible outcomes

Question 6

is a wide return distribution or a narrow riskier

Answer 6

a wide is risker because outcomes are probable

Question 7

what does standard deviaton measure

Answer 7

the dispersion of possible outcomes

Question 8

for a single asset standalone risk =

Answer 8

standard deviation

Question 9

If returns are normally distributed the actual returns will have

Answer 9

a 68% chance of being within plus or minus two standard deviations from the mean

a 95% chance of being within two standard deviations of the mean

Question 10

for investments what do analysts use to forecast the investments risk?

Answer 10

historical data

Question 11

what is correlation coefficient

Answer 11

measures how two variables move together

Question 12

what is a stock portfolio

Answer 12

a mix of stocks

Question 13

what does a correlation of -1 mean for two stocks

Answer 13

the 2 stocks can be combined to form a riskless portfolio: has a standard deviation of 0

Question 14

what does a correlation of +1 mean for two tocks

Answer 14

the risk is not “reduced”
the portfolios standard deviation is just the average of stocks standard deviatons

Question 15

what does it mean if 2 stocks correlation is between -1 and 1

Answer 15

risk is reduced but not eliminated

Question 16

What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added?

Answer 16

standard deviation would decrease because the added stocks would not be perfectly
correlated

Question 17

what does standalone risk =

Answer 17

market risk + diversifiable risk

Question 18

what is market risk

Answer 18

part of securities standalone risk that cannot be eliminated by diversification (war, recession, high interest rates)

Question 19

what is diversifiable risk

Answer 19

part of stand-alone risk but can be eliminated by diversification

“lawsuits, winning or losing major contract”

Question 20

investors bear only what risk?

Answer 20

market risk

Question 21

are investors more concerned with risk of portfolio or individual security

Answer 21

portfolio

Question 22

how do you measure the relevant risk of an individual stock?

Answer 22

CAPM - capital asset pricing model

Question 23

what is a stocks relevant risk

Answer 23

the contribution it has to a well-diversified portfolio risk

Question 24

what is the measure of a stocks relevant risk

Answer 24

beta

Question 25

what does beta measure

Answer 25

how much risk a stock contributes to a well-diversified portfolio

Question 26

what does a high beta lead to

Answer 26

high standard deviation - high risk

Question 27

a stock with a high correlation with the market will also have

Answer 27

large beta - has more of an impact with raises and lowers in the market so more risky

Question 28

what is the beta of a portfolio

Answer 28

weighted average of all betas of the stocks in the portfolio

Question 29

how can beta be estimated

Answer 29

use past period information or by regressing stock returns on market returns

Question 30

what does Ri mean

Answer 30

required rate of return on stock i

Question 31

what does Rrf mean

Answer 31

risk free rate

Question 32

what does Rm mean

Answer 32

required rate of return on the market portfolio

Question 33

what does RPm mean

Answer 33

risk premium on the market

Question 34

what does RPi mean

Answer 34

risk premium on stock i

Question 35

what does the security market line show?

Answer 35

how to determine the return required for bearing a stock’s risk

Question 36

If you increase Risk free rate how does it affect your required rate of reutrn

Answer 36

increases it

Question 37

In market equilibrium what must market price of security equal

Answer 37

intrinsic value

Question 38

when is a security a “bargain”

Answer 38

• when the market price is below intrinsic value
• when the expected return is above the required return

Question 39

in market equilibrium the expected return on a security must equal its…

Answer 39

required return

Question 40

What is the Efficient Market Hypothesis (EMH)

Answer 40

1. Stocks are always in equillibrium
2. It is impossible for investors to beat the market and consistently earn a higher rate of return than is justified by the stocks risk

Question 41

what is weak-form EMH

Answer 41

Current prices already reflect all the information “contained” in past prices,
so you cannot earn excess returns with strategies based on past prices

Question 42

What is semi-strong form EMS

Answer 42

Current prices already reflect all publicly available information, so analyzing a
company is fruitless

Question 43

what are the two exceptions that can earn excess returns in a semistrong form EMH

Answer 43

• small companies and
• companies with high book-to-market ratio

Question 44

what are the two exceptions that can earn excess returns in a weak-form EMH

Answer 44

• short term momentum
• long-term reversals

Question 45

what is strong-form EMH

Answer 45

all information even inside information is embedded in stock prices

• It’s illegal cause excess returns can be gained by trading insider information

Question 46

What are market bubbles

Answer 46

prices climbs super high and theyre alot of new investors and then the bubble pops and prices fall quickly

Question 47

what does a market bubble imply about EMH

Answer 47

if there is a bubble why