Chapter 8

Question 1

Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return?

Answer 1

• T-bills will return the promised 3.0%, regardless of the economy
• No, T-bills do not provide a completely risk-free return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time
• T-bills are also risky in terms of reinvestment risk
• T-bills are risk-free in the default sense of the word.

Question 2

Expected Rate of Return

Answer 2

The weighted average of the probability distribution of possible results

Question 3

Stand-Alone Risk

Answer 3

The risk and investor would face is he or she held only one asset

Question 4

Standard Deviation

Answer 4

A statistical measure of the variability of a set of observations

Question 5

Variance

Answer 5

Mean of squared deviations around the means

Question 6

Coefficient of Variation

Answer 6

A standardized measure of dispersion about the expected value, that shows the risk per unit of return

Question 7

Comments on Standard Deviation as a Measure of Risk

Answer 7

• Standard deviation (σi) measures total, or stand-alone, risk
• The larger σi is, the lower the probability that actual returns will be close to expected returns
• Larger σi is associated with a wider probability distribution of r

Question 8

Sharpe Ratio

Answer 8

• An alternative measure of stand-alone risk. It looks at excess return relative to risk
• Excess return is asset’s return minus the risk-free rate
• Risk is measured as the standard deviation of the asset’s return
• A risk-free asset will have a Sharpe ratio = 0

Question 9

Risk Premium

Answer 9

The difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities

Question 10

Risk Aversion

Answer 10

Assumes investors dislike risk and : assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities

Question 11

Portfolio

Answer 11

Minimum of two stocks

Question 12

Comments on Portfolio Risk Measures

Answer 12

• The portfolio provides the average return of component stocks, but lower than the average risk
• Why? Negative correlation between stocks

Question 13

How to Create a Portfolio

Answer 13

• Begin with one stock and randomly add more stocks
• More stocks you ass, lower your risk becomes

**Between 15 and 30 stocks is typically key

Question 14

Sources of Risk

Answer 14

• Market Risk

- Diversifiable Risk

Question 15

Market Risk

Answer 15

Portion of a security’s stand-alone risk that cannot be eliminated through diversification; measured by beta

Question 16

Diversifiable Risk

Answer 16

Portion of a security’s stand-alone risk that can be eliminated through proper diversification

Question 17

CAPM/SML

Answer 17

• 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 relevant riskiness of a stock is its contribution to the riskiness of a well-diversified portfolio

Question 18

Can the beta of a security be negative?

Answer 18

• Yes, if the correlation between Stock i and the market is negative (i.e., ρi,m < 0)
• If the correlation is negative, the regression line would slope downward, and the beta would be negative
• However, a negative beta is highly unlikely

Question 19

Verifying the CAPM Empirically

Answer 19

• The CAPM has not been verified completely
• Statistical tests have problems that make verification Statistical tests have problems that make verification almost impossible
• Some argue that there are additional risk factors, other than the market risk premium