Risk and Return Flashcards
How do you calculate the holding period return (HPR)?
HPR = [(end of period price + dividend) / beginning of period price] - 1
HPR = Capital gain yield + dividend yield
HPR = (PT - Po) /Po + Div/Po
How do we denote expected/mean return?
E(r)
How do we calculate the risk premium?
E(r) - rf
What does the holding period return measure?
It is a measure of return of a stock
What is a maturity premium?
Extra average return from investing in long versus short term treasury securities
What is a risk premium?
Expected return in excess of risk free return as a compensation for risk
What is variance?
Average value of squared deviations from the mean.
What are variance and standard deviation a measure of?
Volatility
What is the standard deviation?
Square root of variance
The higher the expected return,….
The higher the risk
As standard deviation of monthly returns increases, what else increases/
Average monthly return
What is diversification?
Strategy designed to reduce risk by spreading a portfolio across many investments
What is unique risk?
Risk factors affecting only that firm.
What can unique risks also be called?
Diversifiable or firm-specific risk
What is market risk?
Economy-wide sources of risk that affect the overall stock market
What are market risks also called?
Systematic or undiversifiable risks
How do you calculate total risk?
Total risk = market risk + unique risk
What does risk ultimately mean?
Uncertainty
What is a portfolio?
It is a collection or combination of financial assets characterised by portfolio (market value) weights that sum to 1
What is a portfolio’s expected rate of return?
It’s the weighted sum of each asset’s rate of return
How do you calculate the expected return of an N-asset portfolio?
r = w1r1 + w2r2 + … + wNrN
r = sigma[wiri] where wi is the weight asset of i in the portfolio by size
What do all the portfolio asset weights sum to?
1
What is the standard deviation of portfolio return not necessarily the same as?
The weighted average standard deviation of individual assets
What is the return on assets pattern depicted by?
Correlation
Why do returns not move together?
Each asset is likely to have some uniqueness against others
An investor invests 𝛽 percent of hid wealth in asset A, and the rest (1-𝛽 ) of his wealth in asset B, with return ra and rb.
How do you calculate the portfolios expected return?
What about the standard deviation of the portfolio?
r = 𝛽 ra + (1 - 𝛽 )rb
Look on slides
What is ρ (rho)?
The correlation coefficient
What is the value of ρ between?
-1 and 1
When two assets become less correlated, what happens to the risk and what does this mean?
The portfolio risk decreases as the correlation decreases, and the return remains the same. Increased diversification.
What is the optimal level of correlation for the lowest risk and greatest diversification?
-1- perfectly negatively correlated
What stays the same regardless of diversification?
Return on the asset
How can firm-specific risks decrease?
By increasing the number of investments in your portfolio
On economic grounds, what two factors prove that increasing your investment portfolio decreases firm-specific risk?
Each investment is a much smaller percentage of the portfolio, muting the effect (positive or negative) on the overall portfolio.
Firm-specific actions can be either positive or negative. In a large portfolio, it is argued, these effects will average out to zero. (Stronger argument)
What remains the same regardless of the number of investments in your portfolio?
Market risk
If the cost of capital is estimated from historical returns or risk premiums, what average should you use?
Arithmetic averages, not compound annual rates of return
Although increasing diversification lowers overall risk, what else do you need to be wary of when adding to your portfolio?
The market risk- how sensitive it is to market movements
Which portfolio has had the lowest average annual nominal rate of return between 1925 and 2010?
Portfolio of Treasury bills
Which portfolio has had the highest average annual nominal rate of return between 1925 and 2010?
Portfolio of small US common stocks
What is an efficient portfolio?
An efficient portfolio is one of the portfolios lies along the line called the efficient frontier. It is one of the combinations of assets that offers the investor the highest return for a given risk, or the lowest risk for a given return.
