chapter 8 - key concepts (risk and rates of return) Flashcards
what is the difference between company-specific
and systematic risk?
Market risk/systematic risk: affects a large number of asset classes
company-specific risk/unsystematic risk: only affects an industry or particular company.
which risk can be diversified away?
unsystemic/company-spcific risk
company-specific/unsystematic risk
Stand-alone or idiosyncratic risk
Results only impacts that firm
Risk specific to an individual stock/asset.
Risk can be reduced by diversification
market/systematic risk
Results: If economy is weak profits go down - impacts not only them but every other company if the economy as a whole is doing bad
Risk of overall portfolio
Risk can’t be reduced by diversification!
which risk is an investor compensated for?
idk maybe systematic risk?
why are T-bills considered to be risk-free assets?
t-bills are dubbed the risk-free rate
treasury bills are issued by the government so they will return the promised 3.0%, regardless of the economy.
t-bills do not provide a completely risk-free return, as they are still exposed to inflation. (nominal is not the same as real)
t-bills are risk-free in the default sense of the word.
are t-bills risk free? what are the possible risk factors they are exposed to? why do we used them as the risk-free rate?
T-bills do not provide a completely risk-free return, as they are still exposed to inflation. (nominal is not the same as real)
very little unexpected inflation is likely to occur over such a short period of time so we use them as the risk-free rate
does a stock with a beta of 2 have a HIGHER RATE OF EXPECTED RETURN than a stock with a beta of 0.5?
If beta > 1.0, the stock is riskier than average.
If beta < 1.0, the stock is less risky than average, less risky than market
2 will have a higher rate of expected return than 0.5 –> a beta of .5 means that the stock half as risky as the market portfolio – should have lower returns.
what is the expected rate of return for a stock with a zero beta?
Risk-less securities have a beta of 0, so the return is the risk-free rate
β = 0 means the stock has no systematic risk. Hence, the portfolio’s expected rate of return is the risk-free rate (4%)
if a stock’s beta is above 1, what does that
mean?
If beta > 1.0, the stock is riskier than average.
If beta < 1.0, the stock is less risky than average, less risky than market
if one stock has a higher standard deviation than
another stock, is the stock more or less risky?
if a stock has a higher standard deviation than another, the stock is riskier… (the larger σi is, the lower the probability that actual returns will be close to expected returns.)
the smaller the standard deviation, the tighter the probability distribution and the lower the risk.
what is risk premium? what is risk aversion?… are investors always risk averse?
risk premium: the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities
risk aversion: assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities.
are investors always risk averse: individual investors are almost always risk averse, meaning that they have a mindset where they exhibit more fear over losing money than the amount of eagerness they exhibit over making money.
if two stocks have a perfect correlation, would a
portfolio consisting of these two stocks have
more, less, or the same amount of risk as a
portfolio consisting of only one of these stocks?
If the stock is perfectly correlated (correlation coefficient = 1), then there are no diversification benefits.
Most stocks are positively (though not perfectly) correlated with the market (i.e., ρ between 0 and 1).
two would have more risk…Many stocks are positively correlated with each other and the overall stock market, which can make diversification with only stocks difficult.
what correlation coefficient would an investor
most want?
anything below 1
What is the average coefficient for most
stocks?
Most stocks are positively (though not perfectly) correlated with the market (i.e., ρ between 0 and 1)
when do the diversification benefits of adding
stocks to a portfolio tend to decrease?
Eventually the diversification benefits of adding more stocks dissipates (after about 40 stocks), and for large stock portfolios, σp tends to converge to 20%.
what is the average standard deviation of a
portfolio?
σ ~35% for an average stock.
what is the capm?
most individuals hold stocks as a portfolio, so we need a way to analyze the risk of a stock in a portfolio of assets
This is where the CAPM comes in:
the Capital Asset Pricing Model states that any stock’s required return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification
know how to calculate the CAPM required
rate of return for a stock (beta)
Calculating CAPM required rates of return
ri = rRF + (rM – rRF)bi
EX: What is the CAPM required rate of return if the market risk premium is 8%, the risk-free rate is 2%, and the stock’s beta is 1.0?
Ri = 2% + (8%)*1.0 = 10%
Would technology companies have a high or
low beta? What about growth stocks? (remember this for the exam - look at lecture notes)
tech companies: 9.9% expected return & 1.31 beta
growth: low???
(need more info)
what is a beta
Beta is a concept that measures the expected move in a stock relative to movements in the overall market.
We use beta coefficient as a measure of a stocks’ riskiness in a portfolio.
how are betas calculated and what does the slope of the line represent?
The slope of the regression line is defined as the beta coefficient for the security.
find Ri
ri = rRF + (rM – rRF)bi = must know formula
can a stock’s beta be negative? When would
this happen?
Yes, if the correlation between Stock i and the market is negative (i.e., ρi,m < 0).
EX:
ri = rRF + (rM – rRF)bi
Rrf = 3%, Rm = 8%, beta =-1.0
Ri = 3% + (8%-3%)*-1.0 = 3% + -5% = -2%
If the correlation is negative, the regression line would slope downward, and the beta would be negative.
However, a negative beta is highly unlikely.
what is the market risk premium?
The market risk premium is the additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.
