Chapter 2 Flashcards
Risk and Return
what do investors like and dislike
return and dislike risk
what are investment returns
investment returns measure the financial performance of an investment
what is investment risk
investment risk is exposure to the chance of earning less than expected
how can an asset risk be analyzed
- on a standalone basis (considered in isolation)
- Portfolio basis (the asset is held as one of a number of assets)
what is expected rate of return
the weighted average of the possible outcomes
is a wide return distribution or a narrow riskier
a wide is risker because outcomes are probable
what does standard deviaton measure
the dispersion of possible outcomes
for a single asset standalone risk =
standard deviation
If returns are normally distributed the actual returns will have
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
for investments what do analysts use to forecast the investments risk?
historical data
what is correlation coefficient
measures how two variables move together
what is a stock portfolio
a mix of stocks
what does a correlation of -1 mean for two stocks
the 2 stocks can be combined to form a riskless portfolio: has a standard deviation of 0
what does a correlation of +1 mean for two tocks
the risk is not “reduced”
the portfolios standard deviation is just the average of stocks standard deviatons
what does it mean if 2 stocks correlation is between -1 and 1
risk is reduced but not eliminated
What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added?
standard deviation would decrease because the added stocks would not be perfectly
correlated
what does standalone risk =
market risk + diversifiable risk
what is market risk
part of securities standalone risk that cannot be eliminated by diversification (war, recession, high interest rates)
what is diversifiable risk
part of stand-alone risk but can be eliminated by diversification
“lawsuits, winning or losing major contract”
investors bear only what risk?
market risk
are investors more concerned with risk of portfolio or individual security
portfolio
how do you measure the relevant risk of an individual stock?
CAPM - capital asset pricing model
what is a stocks relevant risk
the contribution it has to a well-diversified portfolio risk
what is the measure of a stocks relevant risk
beta
what does beta measure
how much risk a stock contributes to a well-diversified portfolio
what does a high beta lead to
high standard deviation - high risk
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
what is the beta of a portfolio
weighted average of all betas of the stocks in the portfolio
how can beta be estimated
use past period information or by regressing stock returns on market returns
what does Ri mean
required rate of return on stock i
what does Rrf mean
risk free rate
what does Rm mean
required rate of return on the market portfolio
what does RPm mean
risk premium on the market
what does RPi mean
risk premium on stock i
what does the security market line show?
how to determine the return required for bearing a stock’s risk
If you increase Risk free rate how does it affect your required rate of reutrn
increases it
In market equilibrium what must market price of security equal
intrinsic value
when is a security a “bargain”
- when the market price is below intrinsic value
- when the expected return is above the required return
in market equilibrium the expected return on a security must equal its…
required return
What is the Efficient Market Hypothesis (EMH)
- Stocks are always in equillibrium
- It is impossible for investors to beat the market and consistently earn a higher rate of return than is justified by the stocks risk
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
What is semi-strong form EMS
Current prices already reflect all publicly available information, so analyzing a
company is fruitless
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
what are the two exceptions that can earn excess returns in a weak-form EMH
- short term momentum
- long-term reversals
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
What are market bubbles
prices climbs super high and theyre alot of new investors and then the bubble pops and prices fall quickly
what does a market bubble imply about EMH
if there is a bubble why
