Module 53.1: Systemic Risk and Beta

Question 1

What is the standard deviation and correlation of returns for a risk free asset?

Answer 1

zero standard deviation and zero correlation of returns

Question 2

What is the capital allocation line (CAL)?

Answer 2

it is the possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets.

Question 3

For an individual investor, what is the most optimal CAL?

Answer 3

the one that offers the most-preferred set of possible portfolios in terms of their risk and return.

Question 4

What is the optimal CAL for the homogeneous investor?

Answer 4

Tangent to the efficient frontier.

Question 5

What is the equation for expected return of the capital market line (optimal CAL)?

Answer 5

E(rp) = Rf + ( (Erm - rf) / standard deviation of M) * standard deviation of P

Question 6

What is unsystematic risk and systematic risk?

Answer 6

unsystematic - the risk that is eliminated by diversification (unique, diversifiable, firm-specific risk).

systematic - risk that cannot be diversified away

Question 7

As you include more securities in the portfolio, can you diversify away all the risk?

Answer 7

no, you can only diversify unsystematic risk, and will be left with systematic risk.

Question 8

Why may a stock with higher total return have a lower equilibrium rate of return?

Answer 8

because higher systematic risk equals a higher expected return.

Question 9

What are the three factors typically used in a return generating model?

Answer 9

1) Macroeconomic
2) Fundamental
3) Statistical factors

Question 10

What is the formula for market return premium using a multifactor model?

Answer 10

= beta1 x expected return of factor 1 + beta2 x expected return of factor 2 …

Question 11

What is Fama and French multifactor model?

Answer 11

expected excess return above risk free can be derived from 3 factors: 1) firm size 2) firm book value to market value ratio 3) return on the market portfolio minus the risk free rate.

Question 12

What is the formula for the single factor model (CAPM)

Answer 12

excess return over risk free = beta x (market premium - risk free rate)

Question 13

What is the market model for excess return?

Answer 13

Ri = ai + bi * Rm + ei

ai = intercept
bi = slope coefficient
ei = abnormal return on asset i

Question 14

What is the formula for beta?

Answer 14

Covi,m / variance of market return

or

correlation i,m * (standard deviation of i / standard deviation of m)

Question 15

What is the beta of the market?

Answer 15

1