Chapter 6 & 25

Question 1

risk aversion

Answer 1

investor dislikes risk and requires a higher rate of return as an inducement to buy riskier securities

Question 2

Specify how risk aversion influences required rates of return.

Answer 2

-he or she will demand a greater rate of return for a risky investment to compensate themselves for this risk element. Therefore, in summary, riskier investments will attract greater rate of returns.

Question 3

how is an asset’s risk analyzed?

Answer 3

1) on a stand alone basis where the asset is considered in isolation
2) part of a portfolio (collection of assets)

stand alone risk- risk if u held only this one asset

Question 4

discrete probability distribution

Answer 4

probability distribution showing all possible outcomes with a probability assigned to each outcome.

must equal to 1.0 or 100%

Question 5

standard deviation

payoff matrix

Answer 5

measure the tightness of the probability distribution. provides an idea of how far above or below the expected value to the actual value will be
large st. dev= widely dispersed = riskier
small st. dev = safer

when the outcomes are cash flows or returns

Question 6

continuous probability distribution

normal distribution

Answer 6

1. have an infinite number of possible outcomes
2. the actual return will be within +/- 1 standard deviation of the expected return 68.26% of the time, 95.46% for +/- 2 st dev and 99.74% for +/- 3 st dev.

Question 7

diversification

Answer 7

reducing risk because you’re holding a portfolio of assets that aren’t perfectly correlated. if a portfolio’s standard deviation is less than the weighted average of the individual stock’s standard deviations, then diversification benefits.

Question 8

creating a portfolio

Answer 8

-portfolio is a collection of assets. the weight of an asset is the % of the portfolio’s total value that’s invested in the asset. ex: if you invest $1000 in each of 10 stocks, your portfolio has a value of 10K and each stock has a weight of 1000/10,000 = 10%

weights sum to 1 or 100%

Question 9

correlation

correlation coeffecient

Answer 9

1. tendency for 2 variables to move together
2. standardized measure of how 2 random variables covary. a CC of +1.0 means the two variables move up and down in perfect sync, -1.0 means they move in opp directions. 0 means they aren’t related to each other - independent.

Question 10

What is meant by perfect correlation, perfect negative correlation and zero correlation?

Answer 10

Perfectly correlation: (p=1.0)the returns of two stocks perfectly correlated would result is diversification being useless, stocks move up and down with each other and are just as risky as if each stock was held alone

Perfect negative correlation: (p=-1.0) all risk can be diversified away between two stocks

Zero correlation: returns of two stocks are not rated to one another

Question 11

capital asset pricing model (CAPM)

Answer 11

• answers: how do u measure the amount of market risk an individual stock brings to a well-diversified portfolio?
• the stock’s relevant risk is its contribution to a well diversified portfolio’s risk. (smaller than a stock’s stand alone risk)
• relevant risk of an individual stock is the amount of risk that the stock contributes to the market portfolio.

Question 12

Understand the difference between the Capital Market Line and the Security Market Line.

Answer 12

1. relationship between expected return and
2. relationship between the risk of an asset as measured by its beta and the required rates of return for individual securities. One of the key results of CAPM.

Question 13

State the basic proposition of the Capital Asset Pricing Model (CAPM) and explain how and why a portfolio’s risk may be reduced.

Answer 13

CAPM suggests that there is a Security Market Line (SML) that states that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification.
the risk and return of an individualstock should be analyzed in terms of how the security affects therisk and return of the portfolio in which it is held.
Rp = w1r1 … + WnRn
Rp = expected return on a portfolio
W1 = weight (%) of an asset
Beta measures risk in a portfolio and market
o Model that says the only thing that matters is beta - measures market risk
o Reduce risk by diversifying

Question 14

Understand and be able to discuss how the beta coefficient of a particular stock is calculated.

Answer 14

measure of the amount of risk an individual stock i contributes to a well-diversified portfolio.

high standard deviation = high beta.

Question 15

Security Market Line (SML).

Answer 15

general concept to show that a stock’s risk premium is equal to the product of the stock’s beta and the market risk premium.
-market risk premium: extra rate of return that investors require to invest in the stock market

Question 16

key points about beta

Answer 16

1. shows how much risk a stock contributes to a well diversified portfolio
2. avg of all stocks betas = 1; beta of the market also= 1(market return is the avg of all the stocks returns)
3. stock with a beta > 1 conributes more risk to a portfolio than does the avg stock and a stock with a beta < than 1 contributes less risk to a portfolio than the avg stock
4. most stocks have betas between 0.4 and 1.6

Question 17

Explain how beta is estimated in practice and how beta is related to covariance of returns between a stock and the market in general.

Answer 17

-generally calculate by using data from some past period and then assume that the stock’s risk will be the same in the future as it was in the past.

Question 18

Explain how the choice of 1) market index, 2) holding period and 3) estimation period might each affect beta calculations.

Question 19

diversifiable risk vs market risk

Answer 19

diversifiable risk- unsystematic risk/company specific risk. cause by random events like lawsuits, strikes, major contracts, and other events unique to a firm. this part of a stock’s risk can be eliminated

market risk- systematic risk. stems from factors that affect most firms like war, inflation, recession, high interest rates. part of a stock’s risk that can’t be eliminated.

Question 20

what does r^2 measure? what is typical for a company?

Answer 20

degree of dispersion on the regression line.

avg is 0.32

Question 21

slope of SML

Answer 21

market risk premium. (Rm - Rrf)
the greater the average investor’s aversion to risk., the steeper the slope of the line, higher risk premium for stocks and required rate of return on stocks.

Question 22

In other words, explain why and when the SML might shift up and down or change slope.

Answer 22

if investors become more averse to risk, the slope becomes steeper. the greater the risk the steeper the slope, the greater the risk premium for all stocks and the higher the required rate of return on all stocks

Question 23

Understand and be able to explain the efficient markets hypothesis (EMH)

Answer 23

• says that stocks are always in equilibrium and its impossible for an investor to beat the market. required return equals expected return

Question 24

Weak form efficiency

Answer 24

all info contained in past price movements is fully reflected in current markets.

ex: why sell a stock if you know the price is going to increase by 10% the next day? (based on past movements)
tests: studies show portfolios with poor past long term performance tend to do slightly better in the long term future. stocks with strong performance short term do better short term

Question 25

semi strong form efficiency

Answer 25

• current market prices reflect all publicly available information.
• investors should expect to earn returns based on what they risked, nothing more or less.

tests: small companies have had historical return greater than predicted. companies with high book to market ratios have had higher returns

Question 26

strong form of efficiency

Answer 26

current market prices reflect all pertinent information: public and private.

tests: those who have inside info make and have made sus profits. (jail, illegal)

Question 27

Understand and be able to explain the Fama-French Three-Factor Model.

Answer 27

an asset pricing model that expands on the capital asset pricing model by having one factor for the market return, one for size effect, and last for book to market effect,

Question 28

anchoring bias
herding behavior
loss aversion

Answer 28

1. when predictions of future are influenced too heavily by recent events (causes overconfidence bc ppl think a stock could keep increasing) aka gamblers too
2. following what another investors doing instead of what they think bc its going well
3. when you hate a loss more than you like the gain of the same amount. ex: you hate a loss of $100 more than a gain of $100.

Question 29

Identify concerns about beta and the CAPM.

Answer 29

can’t observe beta, have to estimate it. small stocks and stock with high B/M ratios have higher returns than CAPM predicts

Question 30

Understand and be able to explain the Arbitrage Pricing Theory (APT). In particular, understand how it is different from the SML and CAPM

Answer 30

• measure the risk/return relationship with multiple factors not just the market return used by CAPM.
• APT is more complicated and uses more than one factor so it’s harder

Question 31

expected rate of return vs required return

Answer 31

expected is what the investor expects he will lose or gain on an investment
required return is the minimum expected return required to make an investor purchase the stock

Question 32

shape for a probability distribution for completely certain and uncertain returns

Answer 32

1. certain - vertical line

2. uncertain - x axis

Question 33

compare which security is riskier

Answer 33

if its held in a diversified portfolio, the lower beta and negative correlation with other stocks is less riskier.
in a single asset portfolio, the higher the st. deviation, the riskier

Question 33

compare which security is riskier

Answer 33

if its held in a diversified portfolio, the lower beta and negative correlation with other stocks is less riskier.
in a single asset portfolio, the higher the st. deviation, the riskier