Lecture 2: Risk and Return in Capital Markets (Chapter 11)

Question 1

What is the capital market in Malaysia called?

Answer 1

It is called Bursa Malaysia

Question 2

What are the types of investment?

Answer 2

• Standard & poor’s 500: leaders in respective industries and among largest firms in terms of market capitalization.
• Small stocks: portfolio updated quarterly, stocks traded on NYSE w/ market capitalization of < 20%
• World portfolio: portfolio of international stocks from all of the world’s major stock markets
• Corporate bonds: portfolio of long-term, AAA rated US corporate bond w/ maturities of more than or equals to 20 years
• Treasury bills: investment in one-month US treasury bills (short-term) it is gov guaranteed, thus it’s risk-free

Question 3

Why are investors said to be risk-averse?

Answer 3

Because they’re unwilling to take risks. They require riskier investment to provide them with a higher return. The lower the risks, the lesser the return.

Question 4

Among all types of investments, small stocks have highest return. Why is that so?

Answer 4

Since small stocks experience the largest fluctuations during depression / recession as compared to the rest of the investments, this implies that it bears the highest risk. Thus, higher risks leads to higher returns in the long-run.

Question 5

Why does treasury bills have the least return out of all investments?

Answer 5

It is because it is risk-free. Treasury bills are gov. guaranteed and therefore will not experience any losses / fluctuations. Instead, it only enjoys steady and stable gains every year.

Question 6

Since investors are risk-averse, what do they require specifically?

Answer 6

They demand a risk premium for bearing those risks. However, only certain risks are entitled to risk premium since investors can eliminate some risks by holding large portfolios of stocks.

Question 7

What are realized return/ total return?

Answer 7

It is the total return that occurs over a particular time period.
Realized return / Total return = Dividend yield + Capital gain

Question 8

What happens if we ignore either dividend yield or capital gain/(loss) in the computation of realized return?

Answer 8

This would give a very misleading impression of the co.’s performance.

Question 9

For quarterly returns, how do we compute the annual realized return (R annual)?

Answer 9

1 + R annual = (1+R1)(1+R2)(1+R3)(1+R4)

= 1 - Ans

Question 10

What is Average Annual Returns (AAR)?

Answer 10

It is the average of realized returns for each year. It provides an estimate of the return we should expect in a given year.
Average annual return = 1/T (R1+R2+R3…+Rt)

Question 11

How do we determine the variability of returns?

Answer 11

It is done by calculating the standard deviation of distribution of realized returns.

Question 12

What is variance?

Answer 12

It measures the variability in returns by taking the different of returns from the average return and squaring those differences.
(VAR) = 1/(T-1) [(R1-AAR)^2+(R2-AAR)^2+…+(Rt-AAR)^2]

Question 13

What is standard deviation?

Answer 13

It is obtained through the square-root of variance.
It measures risk (how far form the average returns, tendency of historical returns differing from average returns).
It describes the normal distribution table.
It also captures our intuition of risks.
SDR = (VAR)^1/2

Question 14

What does a high standard deviation indicate?

Answer 14

It indicates the volatility of that particular investment. The higher the standard deviation, the more volatile and risky the investment is.

Question 15

How do we find the variance?

Answer 15

Firstly, we have to find the average annual returns. Then from there only apply the formula stipulated above.

Question 16

How to find the normal distribution?

Answer 16

Average annual return +- (2 x standard deviation)

Question 17

What can we say about the returns of large portfolios?

Answer 17

Investments with higher volatility, as measured by standard deviation, tend to have higher average returns. (Riskier/more volatile investments must offer investors with higher average returns to compensate them for the high risk they’re bearing).

Question 18

What can we say about the returns of individual stocks?

Answer 18

Larger stocks have lower volatility overall. Largest stocks are typically more volatile than a portfolio of large stocks.
The standard deviation of an individual security doesn’t explain the size of its average return. (doesn’t support the phrase “risk-averse”). Only applies to individual stocks (they generally bears the higher risks but have lower returns)

Question 19

How do the effect of volatility differ in large portfolios vs. individual stocks?

Answer 19

The volatility of an individual security doesn’t explain the size of its average return, unlike in large portfolios where the degree of volatility is directly proportional to the average amount of return.

Question 20

What is common risk?

Answer 20

If one is affected, then all will also be affected (vice versa). This type of risk cannot be eliminated (systematic risks).

Question 21

What is independent risk?

Answer 21

If one is affected, the other isn’t affected. Risk can be eliminated (unsystematic risk)

Question 22

What is diversification?

Answer 22

It is the averaging out of risks in a large portfolios (unsystematic risk can be eliminated fully, while systematic risk will always remain).

Question 23

What are the 2 types of news that stock prices are impacted by?

Answer 23

1. Company or industry specific news - good/ bad news about a co./ industry itself (unsystematic risk)
2. Market wide news - news that affects the economy as a whole and therefore affects all stocks in the market (systematic risk)

Question 24

What is unsystematic risks?

Answer 24

Fluctuations of stocks return are due to company/ industry specific news (independent risk)

Question 25

What is systematic risk?

Answer 25

Fluctuations of stocks return are due to market-wide news, all stocks are affected simultaneously. (common risks)

Question 26

What happens if we combine many stocks in a large portfolio?

Answer 26

The unsystematic risks will average out and be eliminated partially or sometimes fully by diversification.
Note: Only unsystematic risks can be eliminated by through diversification. Systematic risks will always remain no matter what. Thus, risk premium is used to compensate systematic risk that cannot be diversified away.

Question 27

Does diversifiable risk have risk premium?

Answer 27

The answer is no. Diversifiable risk have zero risk premium. Investors are not compensated for holding unsystematic / independent risks as it can be diversified away or eliminated fully by having a large portfolio. The risk premium is zero for diversifiable risk because this would increase the share price, causing the co.’s expected returns to decrease.

Question 28

How can systematic risks be reduced slight? (NOT fully eliminated bcs cannot)

Answer 28

It can be reduced slightly by selling stocks & investing in risk-free bonds but at the cost of giving up higher expected return of stocks.

Question 29

Why is systematic risk important?

Answer 29

The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk (unsystematic risk).
In conclusion, there isn’t any relationship between volatility and average returns for individual stocks/ securities, unlike in large portfolios where there is a direct relationship.