Chapter 8 Flashcards
a collection or group of assets
portfolio
measure of uncertainty surrounding the return that an investment will earn, or more formally, the variability of returns associated with a given asset.
risk
total gain or loss experienced on an investment over a period of time; calculated by dividing the asset’s cash distributions during the period, plus change in value, by its beginning-of-period investment value.
total rate of return
_____ has maturities of 1 year or less, while ___ has maturities ranging up to 30 years.
bills, bonds
three different categories of risk:
risk aversion, risk neutrality, risk seeking.
the attitude toward risk in which investors require an increased return in compensation for an increase in risk.
risk aversion
the attitude toward risk in which investors choose the investment with the higher return regardless of risk.
risk neutrality.
attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.
risk seeking
approach for assessing risk that uses several possible alternative outcomes to obtain a sense of variability among returns.
scenario analysis
Measure of an assets risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.
Range
Three different outcomes expected with range: pessimistic, __________ and optimistic
Most likely
The chance that a given outcome will occur.
Probability.
Model that relates probabilities to the associated outcomes.
Probability distribution
Simplest type of probability distribution is the
Bar chart
A probability distribution showing all the possible outcomes and associated probabilities for a given event.
Continuous probability distribution
Most common statistical indicator of an assets risk; measures the dispersion around the expected value.
Standard deviation.
Average return that an investment is expected to produce over time.
Expected value of a return.
Investments with higher returns have higher
Standard deviations.
Higher standard deviations are associated with ____ risk, which confirms a positive correlation between risk and return. This correlation reflects risk aversion by market participants.
Greater
Symmetrical probability distribution whose shape resembles a bell shaped curve.
Normal probability distribution.
___% of possible outcomes will lie between 1 standard deviation, ___% will lie between 2 standard deviations from expected return, and ___% between 3 standard deviations.
68, 95, 99
Measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns.
Coefficient of variation.
Portfolio that maximizes return for a greater level of risk, or minimizes risk for a given level of return.
Efficient portfolio
Underlies the process of diversification that is used to develop an efficient portfolio.
Correlation.
Weighted average of the returns on the individual assets from which it is formed.
Return on a portfolio
Statistical measure of the relationship between any two series of numbers.
Correlation
Describes two series that move in the same direction.
Positive correlation
Describes two series that move in opposite directions.
Negative correlation
Measure of the degree of correlation between two series.
Correlation coefficient
Describes two positively correlated series that have a correlation coefficient from +1
Perfectly positively correlated
Describes two negatively correlated series that have a correlation coefficient of -1.
Perfectly negatively correlated
To reduce overall risk, if is best to ______ by combining or adding to the portfolio, assets that have lowest possible correlation. Combining assets that have a low correlation with each other can reduce the overall variability of a portfolios return.
Diversifying
Describes twos Erie’s that lack any interaction and therefore have a correlation coefficient close to zero.
Uncorrelated
In general, the lower the correlation between asset returns, the ___ the risk reduction that investors can achieve by diversifying.
Greater
Over long periods, _____ diversified portfolios tend to perform better than _____ portfolios.
International, domestic.
Risk that arises from the possibility that a host government will take actions harmful to foreign investors or that political turmoil will endanger investments.
Political risk
Basic theory that links risk and return for all assets.
Capital asset pricing model (CAPM)
Combination of a security’s non diversifiable risk and diversifiable risk.
Total risk
Portion of an assets risk that is attributable to firm specific, random causes; can be eliminated through diversification. Also called unsystematic risk.
Diversifiable risk.
Relevant portion of an assets risk attributable to market factors that affect all firms; cannot be eliminated through diversification. Also called systematic risk.
Nondiversifiable risk
The only relevant risk is
Nondiversifiable risk is systematic risk
Relative measure of nondiversifiable risk. degree of movement of an assets return in response to a change in the market return.
Beta coefficient.
The return on the market portfolio of all traded securities.
Market return.
The beta coefficient for the entire market equals
1
The required return on a risk free asset, typically a 3 month US treasury bill.
Risk free rate of return.
Short term IOU’s issued by the US treasury; considered the risk free asset.
Treasury bills (T-bills)
The depiction of the capital asset pricing model as a graph that reflects the required return in the marketplace for each level of nondiversifiable risk (beta)
Security market line (SML)
When beta < 1, it is
Less risky than the market
When b > 1, it is
Riskier than the market
When b=0, it is
Not related to market/risk free
