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Principles of Finance > Chapter 8 - Risk and Rate of Returns > Flashcards

Chapter 8 - Risk and Rate of Returns Flashcards

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1
Q

What are the 2 types of investment risks?

A
  1. Stand-alone risk

2. Portfolio risk

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2
Q

What is the weighted average return on a risky asset, from today to some future date?

A

Expected rate of return

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3
Q

What is formula to calculate expected rate of return if there are multiple rates?

A

(probability 1 x rate 1) + (probability 2 x rate 2) + (probability 3 x rate 3) + … x 100

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4
Q

What is formula to calculate expected rate of return if there is only one rate?

A

(probability 1 + probability 2 + probability 3 + …) / # of rates

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5
Q

Fill in the Blank: Larger or Smaller

A _____ expected rate of return is better

A

Larger

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6
Q

What is the square root of the variance of expected returns?

A

The standard deviation

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7
Q

What is the formula to calculate the standard deviation?

A

√[prob 1 (rate 1 - asset exp. RoR)^2] + [prob 2 (rate 2 - asset exp. RoR)^2] + …

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8
Q

Fill in the Blank: Larger or Smaller

A _____ standard deviation is riskier

A

Larger

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9
Q

What is a standardized measure of the risk per unit of expected return?

A

The coefficient of variation (CV)

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10
Q

What is the formula to calculate the coefficient of variation (CV)?

A

STD/ Exp. RoR

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11
Q

What is the difference between the return on a risky asset and a riskless asset?

A

Risk premium

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12
Q

What is the formula to calculate the risk premium?

A

Return – Risk Free Rate

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13
Q

What are the groups of assets that are held by investors?

A

Portfolios

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14
Q

What is the proportion of the portfolio’s total value that is invested into each asset?

A

Portfolio weights

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15
Q

What is the weighted average of the returns of a portfolio’s component assets?

A

The portfolio expected rate of return

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16
Q

What is the formula to calculate the portfolio’s expected rate of return?

A

(Asset a weight % x asset a Exp. RoR) + (asset b weight % x asset b Exp. RoR)

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17
Q

What has a profound effect on portfolio expected rate of return and portfolio risk?

A

Diversification

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18
Q

What is a systematic risk also known as?

A

Undiversifiable Risk

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19
Q

What is a unsystematic risk also known as?

A

Diversifiable Risk

20
Q

What is a risk that influences a large number of assets called?

A

A systematic risk

21
Q

What is a risk that influences a single company or a small group of companies called?

A

A unsystematic risk

22
Q

Which coefficient measures the relative systematic risk of an asset?

A

Beta

23
Q

True or False:

All Betas are created equally

A

False

24
Q

What is the formula to calculate the requited rate of return?

A

Risk free rate + beta x (market return - risk free rate)

25
Q

What is the formula to calculate the portfolio beta?

A

(Stock A weight x stock A beta) + (Stock B weight x stock B beta) + (Stock C weight x stock C beta) + …

26
Q

Solve the problem:

Assume You have $100,000 to invest in stock market and you decide to invest $60,000 in DPZ and $40,000 in HD. What is the weight of DPZ’s stock?

A

60,000/100,000 = 0.6 = 60%

27
Q

Solve the problem:

Assume You have $100,000 to invest in stock market and you decide to invest $60,000 in DPZ and $40,000 in HD. What is the weight of HD’s stock?

A

40,000/100,000 = 0.4 = 40%

28
Q

True or False:

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

A

True

29
Q

True or False:

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

A

True

30
Q

True or False:

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio’s risk.

A

True

31
Q

True or False:

Diversification will normally reduce the riskiness of a portfolio of stocks.

A

True

32
Q

True or False:

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM.

A

True

33
Q

True or False:

An individual stock’s diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

A

False

34
Q

True or False:

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock’s contribution to the riskiness of a well-diversified portfolio.

A

True

35
Q

True or False:

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments’ stand-alone risk.

A

True

36
Q

True or False:

“Risk aversion” implies that investors require higher expected returns on riskier than on less risky securities.

A

True

37
Q

True or False:

A stock’s beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

A

False

38
Q

You have the following data on three stocks:

Stock: A STD: 20% Beta: 0.59
Stock: B STD: 10% Beta: 0.61
Stock: C STD: 12% Beta: 1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

a. A; A.
b. A; B.
c. B; A.
d. C; A.
e. C; B.

A

c. B; A.

39
Q

Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

a. Variance; correlation coefficient.
b. Standard deviation; correlation coefficient.
c. Beta; variance.
d. Coefficient of variation; beta.
e. Beta; beta.

A

d. Coefficient of variation; beta.

40
Q

Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct?

a. Stock A would be a more desirable addition to a portfolio then Stock B.
b. In equilibrium, the expected return on Stock B will be greater than that on Stock A.
c. When held in isolation, Stock A has more risk than Stock B.
d. Stock B would be a more desirable addition to a portfolio than A.
e. In equilibrium, the expected return on Stock A will be greater than that on B.

A

e. In equilibrium, the expected return on Stock A will be greater than that on B.

41
Q

Which of the following statements is CORRECT?

a. An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.
b. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
c. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
d. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
e. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

A

e. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

42
Q

Inflation, recession, and high interest rates are economic events that are best characterized as being:

a. systematic risk factors that can be diversified away.
b. company-specific risk factors that can be diversified away.
c. among the factors that are responsible for market risk.
d. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
e. irrelevant except to governmental authorities like the Federal Reserve.

A

c. among the factors that are responsible for market risk.

43
Q

For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?

a. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.
b. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
c. The beta of the portfolio is less than the weighted average of the betas of the individual stocks.
d. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.
e. The beta of the portfolio is larger than the weighted average of the betas of the individual stocks.

A

d. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.

44
Q

Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?

a. Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.
b. Adding more such stocks will increase the portfolio’s expected rate of return.
c. Adding more such stocks will reduce the portfolio’s beta coefficient and thus its systematic risk.
d. Adding more such stocks will have no effect on the portfolio’s risk.
e. Adding more such stocks will reduce the portfolio’s market risk but not its unsystematic risk.

A

a. Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.

45
Q

Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?

a. Portfolio P’s expected return is greater than the expected return on Stock B.
b. Portfolio P’s expected return is equal to the expected return on Stock A.
c. Portfolio P’s expected return is less than the expected return on Stock B.
d. Portfolio P’s expected return is equal to the expected return on Stock B.
e. Portfolio P’s expected return is greater than the expected return on Stock C.

A

d. Portfolio P’s expected return is equal to the expected return on Stock B.

46
Q

Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)

a. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
b. The effect of a change in the market risk premium depends on the slope of the yield curve.
c. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
e. The effect of a change in the market risk premium depends on the level of the risk-free rate.

A

d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.

47
Q

Which of the following statements is CORRECT?

a. The slope of the security market line is equal to the market risk premium.
b. Lower beta stocks have higher required returns.
c. A stock’s beta indicates its diversifiable risk.
d. Diversifiable risk cannot be completely diversified away.
e. Two securities with the same stand-alone risk must have the same betas.

A

a. The slope of the security market line is equal to the market risk premium.

Principles of Finance (8 decks)

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