Chapter 2 Flashcards

Risk and Return

1
Q

what do investors like and dislike

A

return and dislike risk

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2
Q

what are investment returns

A

investment returns measure the financial performance of an investment

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3
Q

what is investment risk

A

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

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4
Q

how can an asset risk be analyzed

A
  1. on a standalone basis (considered in isolation)
  2. Portfolio basis (the asset is held as one of a number of assets)
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5
Q

what is expected rate of return

A

the weighted average of the possible outcomes

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6
Q

is a wide return distribution or a narrow riskier

A

a wide is risker because outcomes are probable

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7
Q

what does standard deviaton measure

A

the dispersion of possible outcomes

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8
Q

for a single asset standalone risk =

A

standard deviation

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9
Q

If returns are normally distributed the actual returns will have

A

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

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10
Q

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

A

historical data

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11
Q

what is correlation coefficient

A

measures how two variables move together

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12
Q

what is a stock portfolio

A

a mix of stocks

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13
Q

what does a correlation of -1 mean for two stocks

A

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

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14
Q

what does a correlation of +1 mean for two tocks

A

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

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15
Q

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

A

risk is reduced but not eliminated

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16
Q

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

A

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

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17
Q

what does standalone risk =

A

market risk + diversifiable risk

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18
Q

what is market risk

A

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

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19
Q

what is diversifiable risk

A

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

“lawsuits, winning or losing major contract”

20
Q

investors bear only what risk?

A

market risk

21
Q

are investors more concerned with risk of portfolio or individual security

22
Q

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

A

CAPM - capital asset pricing model

23
Q

what is a stocks relevant risk

A

the contribution it has to a well-diversified portfolio risk

24
Q

what is the measure of a stocks relevant risk

25
what does beta measure
how much risk a stock contributes to a well-diversified portfolio
26
what does a high beta lead to
high standard deviation - high risk
27
a stock with a high correlation with the market will also have
large beta - has more of an impact with raises and lowers in the market so more risky
28
what is the beta of a portfolio
weighted average of all betas of the stocks in the portfolio
29
how can beta be estimated
use past period information or by regressing stock returns on market returns
30
what does Ri mean
required rate of return on stock i
31
what does Rrf mean
risk free rate
32
what does Rm mean
required rate of return on the market portfolio
33
what does RPm mean
risk premium on the market
34
what does RPi mean
risk premium on stock i
35
what does the security market line show?
how to determine the return required for bearing a stock's risk
36
If you increase Risk free rate how does it affect your required rate of reutrn
increases it
37
In market equilibrium what must market price of security equal
intrinsic value
38
when is a security a "bargain"
- when the market price is below intrinsic value - when the expected return is above the required return
39
in market equilibrium the expected return on a security must equal its...
required return
40
What is the Efficient Market Hypothesis (EMH)
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
41
what is weak-form EMH
Current prices already reflect all the information “contained” in past prices, so you cannot earn excess returns with strategies based on past prices
42
What is semi-strong form EMS
Current prices already reflect all publicly available information, so analyzing a company is fruitless
43
what are the two exceptions that can earn excess returns in a semistrong form EMH
- small companies and - companies with high book-to-market ratio
44
what are the two exceptions that can earn excess returns in a weak-form EMH
- short term momentum - long-term reversals
45
what is strong-form EMH
all information even inside information is embedded in stock prices - It's illegal cause excess returns can be gained by trading insider information
46
What are market bubbles
prices climbs super high and theyre alot of new investors and then the bubble pops and prices fall quickly
47
what does a market bubble imply about EMH
if there is a bubble why