CMA Exam: Study Unit #4

Question 1

Define Return

Answer 1

A return is the amount received by an investor as compensation for taking risk.

ROI = Amt Rec. - Amt. Inv.

Question 2

Rate of Return

Answer 2

Return = ROI / Amt Invested

Question 3

2 types of Risk & their definition

Answer 3

Systemic risk - aka market risk, is faced by all firms; cannot be offset through portfolio diversification

Unsystematic risk - aka company risk, the risk inherent in a particular investment security; can be offset through portfolio diversification

Question 4

7 other types of Investment Risk

Answer 4

1. Credit Risk
2. F/X Risk
3. Interest Rate Risk
4. Industry Risk
5. Political Risk
6. Political Risk
7. Liquidity Risk
8. Financial Risk

Question 5

3 types of risky investors

Answer 5

1. Risk Adverse - has diminishing marginal utility for wealth; i.e. potential gain is not worth add’l risk
2. Risk Neutral - adopts expected value approach because he regards the utility of gain as = to the disutility of a loss of the same amount.
3. Risk Seeking - optimistic attitude toward risk

Question 6

8 Types of Financial Instruments

from least risky to risk

Answer 6

1. U.S. Treasury Bonds
2. 1st Mortgage Bonds
3. 2nd Mortgage Bonds
4. Subordinated debentures
5. Income Bonds
6. Preferred Stock
7. Convertible Preferred Stock
8. Common Stock

Question 7

Expected Rate of Return (E. RoR)

Answer 7

Expected Value Calculation

E.RoR = Sum (Possible RoR x Probability)

Question 8

What does Std. Deviation measure?

Answer 8

riskiness of the investment via the tightness of distribution

The greater the Std. Dev, the riskier the investment

Question 9

How should investment risk be evaluated for a firm?

Answer 9

Based off the entire portfolio, not for individual assets

Question 10

Portfolio Risk

Answer 10

The Risk of a Portfolio is not an avg. of std. deviations of the securities.

Due to the Diversification effect, combining securities results in a portfolio risk that is less than the avg. of std. dev because the returns are imperfectly correlated

Question 11

What is the Correlation Coefficient?

Answer 11

Measures the relationship degree of any 2 portfolio variables, e.g. 2 stocks

1.0 to -1.0; 1.0 = Perfect positive correlation, -1.0 = negative correlation, variables move in opposite direction

Perfect negative correlation, risk would in theory be eliminated

Question 12

What is the Covariance?

Answer 12

Measures the volatility of returns together with their correlation with the returns of other securities

Correlation Coefficient * Std. Dev 1 * Std. Dev 2

Question 13

what is portfolio theory?

Answer 13

Portfolio theory concerns the composition of an investment portfolio that is efficient and balancing the risk with the rate of return of the portfolio.

Asset allocation is a key concept and financial planning and money management.

Question 14

what is beta coefficient?

Answer 14

The sensitivity stated in terms of a stock. it is the effect of an individual security on the volatility of a portfolio that is measured by the sensitivity to movements by the overall market

Question 15

Different types Beta Coefficient

Answer 15

Beta = 1, stock has the same volatility at the overall market.

Beta > 1: be more volatile than average

Beta

Question 16

another option for calculating beta?

Answer 16

The beta for a security may also be calculated by dividing the covariance of the return on the market and the return of the security by the variance of the return on the market

Question 17

what is the CAPM?

Answer 17

Required Rate of Return = Rf + B(Rm - Rf)

formula based on the idea that an investor must be compensated for his or her investment into Waze time value of money and risk.

1. The market risk premium is the return on the market list the risk-free rate of return.
2. securities risk is called Beta, which can be multiplied by the market risk premium and added to the risk-free rate to the terminal expect a return of the security