FRM- 2.0 Flashcards
Not All Investments
- ) Have Same Return and Risk (Why ?)
2. ) E.g. Small Stocks, S&P 500 and Corporate Bonds have Different Return and Risk
Higher Returns are Given
To Compensate for Higher Risks
But Not All Risks Have To Be Compensated
Need to Know Which Risk to Compensate
Quantifying Relationship Between Risks and Returns
- ) To Understand Which Risks to Be Compensated
2. ) How Returns Change with Risks
Higher Return Order:
- ) Small Stocks
- ) S&P 500
- ) World Portfolio
- ) Corporate Bonds
- ) Treasury Bills
Higher Volatility in Returns:
- ) Small Stocks
- ) S&P 500
- ) World Portfolio
- ) Corporate Bonds
- ) Treasury Bills
Measure to Calculate Returns
- Probabilistic Distribution
2. Historical Annual Average Return
Probabilistic Returns
Expected Probability for Different Returns
Historical Annual Average Returns
- ) Realized Returns Based on Dividend- Yield and Capital- Yield
- ) Annual Realized Returns- Emperical Distribution
- ) Probability Distribution Remains Same
- ) Future Mirrors Past
Estimation Error
- ) Expected Return Cannot Be Known
- ) Assume Expected Return
- ) Reduces With Increase in Number of Observations (95 % Confidence Interval)
- ) Limited Due to Change in Market Conditions
Variation
- ) Square Deviation from Mean
2. ) Spread-out of Returns
Standard Deviation
Volatility of Returns
Variation Based on Historical Returns
- ) Divide By T-1
- ) Lost One Observation Due to No Availability of Expected Return
- ) Making Use of Mean as Expected Return
For Small Stocks, S&P 500, Corporate Bonds and Treasury Bills:
Straight Line in Risk- Return Space
Individual Stocks
- ) No Particular Relationship Between Risk and Return
- ) Small Returns As Compared to Portfolios for Same Risks
- ) Risk Depends on the Size of the Stocks
Common and Independent Risks
- ) Earthquake
2. ) Theft
Independent Risks
- ) Get Diversified
2. ) Reduces with Increase in Diversification
Common Risks
- ) Remains Same for All Stocks
2. ) Cannot Be Diversified
Independent Risks
Firm- Specific Risks; Diversifiable Risk; Idiosyncratic Risks
Common Risks
Market Risks; Undiversifiable Risks; Systematic Risk
Arbitrage Rule
- ) Law of One Price
2. ) Risk- Premium for Market Risk Only
Law of One Price
- ) Firm-Specific Risk Can Be Diversified
- ) Increase in Demand Will Lead to Increase in Price of the Stocks- Lowering the Return
- ) Finally, Same Return
Volatility Cannot Be A Measure of Risk for Portfolio
- ) Systematic Risk
2. ) Calculated Using Beta
Beta
% Change in Return Due to % Change in Market Return