Risk and Return Flashcards
What are the different types of investments and how do they differ?
Portfolio of Treasury Bills (“Bills”)
- Short-term government debt securities maturing in less than 1 year
- No default risk (only very small inflation risk)
Portfolio of U.S. government bonds (“Bonds”)
- Long-term government debt instruments
- Very large interest rate risk (Bond prices fall when interest rates rise, and vice versa)
Portfolio of U.S. common stocks (“Stocks”)
- High default risk since corporate bonds but therefore highest potential return
- In case of bankruptcy: Company will first pay out debt and only then repay the equity investments
What is Inflation and how is it measured?
Inflation measures the change in price level of an economy with the help of the annual percentage change in the consumer price index (CPI).
The CPI measures the purchasing power by averaging the price of goods and services in the consumption basket of an average urban family of four.
What is the Equity Risk Premium?
Equity Risk Premium is the premium earned in the long-term by investors willing to invest into and take on the stock market risk as compared to an investment in a risk-free asset
What is diversification and how does it relate to the market premium?
Diversification is a tool to reduce the standard deviation of portfolio returns (risk) by choosing stocks that do not move exactly together (negative covariance).
The risk premium therefore only compensates for the market risk since it cannot be diversified away.
What is the covariance and the correlation coefficient?
Covariance is the statistical measure of the degree to which securities’ returns move together.
Correlation coefficient measures the strength and direction of the linear relationship between two variables and is the standardized version of the covariance that is bound to a (-1,1) inverval.
What is beta?
Beta is the varying degree of sensitivity towards market movements which measures the relative systematic risk between an asset and the market (i.e. the market risk of a respective stock).
Beta describes the level of risk on an investment and amounts to the level of expected change in the expected stock price to a 1% change in the market.