Mean Variance Framework

Question 1

Random Variables are:

Answer 1

•Treat as random variable, r. ◦Can take many values, each with associated probabilities

•Describe with probability distribution. ◦Discrete, with finite set of values (e.g., flipping a coin, rolling a die)
◦Continuous, with range of values (e.g., height of a person, return on investment)

•We can’t anticipate the numbers. (randomness return)

Question 2

What are some factors affecting returns?

Answer 2

• Macroeconomics (e.g., GDP growth, unemployment, weather)

* Company-specific information (bad publicity, new products, litigation)

Question 3

What is Variability

Answer 3

diversity of range of returns

Question 4

What is Volatility?

Answer 4

varied returns

Question 5

What is Uncertainty?

Answer 5

inability to predict returns

Question 6

What is Risk?

Answer 6

potential for undesirable returns

•Acknowledges outcomes are uncertain, and some are undesirable
•Exists in everyday life as well as investing ◦What can go wrong?
◦What is the likelihood that it will go wrong?
◦What is the potential damage? ◾From a catastrophic event
◾From a noncatastrophic event

Question 7

What are the Two Measures of Risk?

Answer 7

• Probability of loss (PoL): probability of earning a low return, and specifically a return less than zero,
• Value at risk (VaR): minimum loss in case of a catastrophic event or disaster

Question 8

What are some characteristics of Stock Returns

Answer 8

•Have normal distributions (a logical assumption)
•Are affected by many factors ◦Economy’s performance
◦Strength of the dollar
◦Plant strike
◦Lower product demand due to competition

•Are limited to −100% (limits validity on the left side of the curve)

Question 9

How does standard deviation associate with risk?

Answer 9

•A higher standard deviation is less desirable due to the higher associated risk.