Risk and Return

Question 1

How do you calculate the holding period return (HPR)?

Answer 1

HPR = [(end of period price + dividend) / beginning of period price] - 1

HPR = Capital gain yield + dividend yield

HPR = (PT - Po) /Po + Div/Po

Question 2

How do we denote expected/mean return?

Answer 2

E(r)

Question 3

How do we calculate the risk premium?

Answer 3

E(r) - rf

Question 4

What does the holding period return measure?

Answer 4

It is a measure of return of a stock

Question 5

What is a maturity premium?

Answer 5

Extra average return from investing in long versus short term treasury securities

Question 6

What is a risk premium?

Answer 6

Expected return in excess of risk free return as a compensation for risk

Question 7

What is variance?

Answer 7

Average value of squared deviations from the mean.

Question 8

What are variance and standard deviation a measure of?

Answer 8

Volatility

Question 9

What is the standard deviation?

Answer 9

Square root of variance

Question 10

The higher the expected return,….

Answer 10

The higher the risk

Question 11

As standard deviation of monthly returns increases, what else increases/

Answer 11

Average monthly return

Question 12

What is diversification?

Answer 12

Strategy designed to reduce risk by spreading a portfolio across many investments

Question 13

What is unique risk?

Answer 13

Risk factors affecting only that firm.

Question 14

What can unique risks also be called?

Answer 14

Diversifiable or firm-specific risk

Question 15

What is market risk?

Answer 15

Economy-wide sources of risk that affect the overall stock market

Question 16

What are market risks also called?

Answer 16

Systematic or undiversifiable risks

Question 17

How do you calculate total risk?

Answer 17

Total risk = market risk + unique risk

Question 18

What does risk ultimately mean?

Answer 18

Uncertainty

Question 19

What is a portfolio?

Answer 19

It is a collection or combination of financial assets characterised by portfolio (market value) weights that sum to 1

Question 20

What is a portfolio’s expected rate of return?

Answer 20

It’s the weighted sum of each asset’s rate of return

Question 21

How do you calculate the expected return of an N-asset portfolio?

Answer 21

r = w1r1 + w2r2 + … + wNrN
r = sigma[wiri] where wi is the weight asset of i in the portfolio by size

Question 22

What do all the portfolio asset weights sum to?

Answer 22

1

Question 23

What is the standard deviation of portfolio return not necessarily the same as?

Answer 23

The weighted average standard deviation of individual assets

Question 24

What is the return on assets pattern depicted by?

Answer 24

Correlation

Question 25

Why do returns not move together?

Answer 25

Each asset is likely to have some uniqueness against others

Question 26

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?

Answer 26

r = 𝛽 ra + (1 - 𝛽 )rb Look on slides

Question 27

What is ρ (rho)?

Answer 27

The correlation coefficient

Question 28

What is the value of ρ between?

Answer 28

-1 and 1

Question 29

When two assets become less correlated, what happens to the risk and what does this mean?

Answer 29

The portfolio risk decreases as the correlation decreases, and the return remains the same. Increased diversification.

Question 30

What is the optimal level of correlation for the lowest risk and greatest diversification?

Answer 30

-1- perfectly negatively correlated

Question 31

What stays the same regardless of diversification?

Answer 31

Return on the asset

Question 32

How can firm-specific risks decrease?

Answer 32

By increasing the number of investments in your portfolio

Question 33

On economic grounds, what two factors prove that increasing your investment portfolio decreases firm-specific risk?

Answer 33

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)

Question 34

What remains the same regardless of the number of investments in your portfolio?

Answer 34

Market risk

Question 35

If the cost of capital is estimated from historical returns or risk premiums, what average should you use?

Answer 35

Arithmetic averages, not compound annual rates of return

Question 36

Although increasing diversification lowers overall risk, what else do you need to be wary of when adding to your portfolio?

Answer 36

The market risk- how sensitive it is to market movements

Question 37

Which portfolio has had the lowest average annual nominal rate of return between 1925 and 2010?

Answer 37

Portfolio of Treasury bills

Question 38

Which portfolio has had the highest average annual nominal rate of return between 1925 and 2010?

Answer 38

Portfolio of small US common stocks

Question 39

What is an efficient portfolio?

Answer 39

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.