Lecture 4- Risk & Return

Question 1

What is the difference between expected payoff and return?

Answer 1

• Payoff: Cash flow from selling the coin

- Expected return is the gain made/ initial cost

Question 2

What is the expected payoff?

Answer 2

investment is the sum of: The payoff in each state multiplied by the probability of that state occurring

Question 3

What does the standard deviation mean?

Answer 3

• Implies a wider dispersion of returns
• The higher the standard deviation the higher the risk
• It measures the total variability i.e. total risk of the stock in isolation

Question 4

What is the only way to persuade a risk averse investor to hold a risky asset?

Answer 4

To increase its returns

Question 5

What is the risk-free rate?

Answer 5

Where investors will require some return even if there is nor risk because of inflation

-It has zero risk

Question 6

What is the risk premium?

Answer 6

-The extra return above the risk free rate, that it has to offer to compensate for the extra risk

Question 7

What is the relationship between standard deviation and returns?

Answer 7

-As the standard deviation goes down so does the returns

Question 8

What is portfolio theory?

Answer 8

-A portfolio is a collection of different assets or investment e.g. shares in several different companies, bonds, gold etc.

Question 9

What is the risk and return of a portfolio dependant on?

Answer 9

• Risk and return of the individual are they risk averse, risk neutral or risk taking
• And the risk and return of the individual components that makeup that portfolio

Question 10

How to work out the expected return on the portfolio?

Answer 10

Times the proportion of the company by the expected return for that part of the company

Question 11

What is diversification?

Answer 11

• Adding extra assets to a portfolio we can reduce the overall risk
• The risk removed by diversification is called unique risk and reflects risk factors unique to each company i.e.unique circumstance of an individuals investment
• It does affect the return for that specific investment, but over the whole portfolio, unique risk tend to cancel eachother out and so can effectively be eliminated

Question 12

What are the market-wide risk factors for all investments?

Answer 12

Oil prices
Interest rates
Inflation
Unemployment

Question 13

What risks cannot be eliminated by diversification?

Answer 13

market risk

-Tescos less affected in recession than jaguar, more of a necessity food than car.

Question 14

Optimum level of stocks in a portfolio/

Answer 14

When the number of stocks is small –big reductions in risk can be gained from diversification

Once the number of stocks hits 10-15, most of the gains from diversification has been made – adding further stocks has little impact

Question 15

Correlation in relation to risk

Answer 15

The amount of risk that can be removed when we combine stocks depends on how they are correlated

Things are said to be correlated if they always tend to move in the same way relative to each other

Think of Sunny weather and ice cream sales Revision and exam grades Train speed and journey times

Financial assets/stocks are often correlated with each other, e.g. Shell & BP, or Barclays & HSBC, Eurotunnel & P&O

Question 16

What is the correlation coefficient?

Answer 16

The correlation coefficient ρ ranges between 1 (perfect negative correlation) to +1 (perfect positive correlation). A figure of zero means there is no correlation between the two assets

If two assets have ρ = -1 then risk can be reduced to zero

If two assets have ρ = +1 then risk can’t be reduced at all

In practice most correlation coefficients lie strictly between -1 and +1, thus risk can generally be reduced but not eliminated

Question 17

What does the standard deviation of each portfolio depend on?

Answer 17

• The proportion of each stock we have

- The correlation coefficient between Stocks X and Y

Question 18

Correlation coefficients to reduce risk and not be able to reduce risk

Answer 18

-1=risk can be reduced ot zero

1=risk ant be reduced at all

Question 19

Market Standard deviation

Answer 19

• Uk stocks have SD of 30-40%
• The market as a whole is normally 20%
• This shows most stocks have a positive correlation around -0.3 and 0.5

Question 20

Going international

Answer 20

-Portfolio for both domestic and international assets reduce risk