Module 7 - Risk and Return Flashcards
Two key financial considerations in most important business decisions
risk and return
a collection, or group, of assets
portfolio
is a measure of uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset
Risk
the total gain or loss experienced on an investment over a given period of time; calculated by dividing the asset’s cash distributions during the period, plus change in value, by its beginning-of-period investment value
Return
T or F: stocks are riskier than bonds, and therefore offer higher potential returns
True
investors require an increased return for an increase in risk
risk averse
investors choose the investment with the higher return regardless of its risk
risk neutral
investors prefer investments with greater risk even if they have lower expected returns
risk seeking
economists use these three categories to describe how investors respond to risk, or their attitude towards risk
Risk averse, risk neutral, risk seeking
risk neutral is also referred to as
risk indifferent
an approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns
Scenario analysis
a measure of an asset’s risk, which is found by substracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome
Range
the chance that a given outcome will occur
probability
a model that relates probabilities to the associated outcomes
probability distribution
the simplest type of probability distribution; shows only a limited number of outcomes and associated probabilities for a given event
bar chart
the most common statistical indicator of an asset’s risk; it measures the dispersion around the expected value
Standard deviation
the average return that an investment is expected to produce over time
expected value of a return
a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns
coefficient of variation
a higher coefficient of variation means that:
an investment has more volatility relative to its expected return
a portfolio that provides maximum return of a given level of risk
efficient portfolio
it is a weighted average of the returns on the individual assets from which it is formed
return on a portfolio
a statistical measure of the relationship between any two series of numbers
correlation
describes two series that move in the same direction
positively correlated
describes two series that move in opposite directions
negatively correlated
measure of the degree of correlation between two series
correlation coefficient
describes two positively correlated series that have a correlation coefficient of +1
perfectly positively correlated
describes two negatively correlated series that have a correlation coefficient of -1
perfectly negatively correlated
describes two series that lack any interaction and therefore have a correlation coefficient close to zero
uncorrelated
it is the basic theory that links risk and return for all assets, quantifies the relationship between risk and return, it measures how much additional return an investor should expect from taking a little extra risk
capital asset pricing model
portion of an asset’s risk that is attributable to firm-specific, random causes; can be eliminated through diversification
Diversifiable (Unsystematic) Risk
relevant portion of an asset’s risk attributable to market factors that affect all firms; cannot be eliminated through diversification
Nondiversifiable (Systematic) Risk
results from uncontrollable or random events that are
firm-specific (e.g. labor strikes, lawsuits, unsuccessful acquisitions).
diversifiable risk
attributable to forces that affect all similar
investments (e.g. war, inflation, political events).
nondiversifiable risk
the combination of a security’s nondiversifiable risk and diversifiable risk
total risk
a relative measure of nondiversifiable risk. an index of the degree of movement of an asset’s return in response to a change in the market return
beta coefficient
is the return on the market portfolio of all traded securities
market return
the CAPM (Capital Asset Pricing Model) can be divided into two parts:
- the risk-free rate of return
2. risk premium
represents the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets
risk premium
other things being equal: the higher the beta, the ___ the required return
the lower the beta, the ___ the required return
higher, lower
