Risk and Return

Question 1

For stocks what is the difference between adjusted and unadjusted?

Answer 1

Adjusted: for changes to the stock (see following explanation)
Unadjusted: with a stock split, the stock price declines. Unadjusted means that you don’t account for stock splits. With Alcon spin-off, the Novartis unadjusted price declined by 12%

Question 2

Why do different investments show different returns?

Answer 2

Because the average annual return on the investments is differently high compared to average inflation. And different possibilities of default risk (not for T-bills, and for bonds in the next 30 years)

Because they have different exposure to idiosyncratic risks and market risk

Question 3

What is the equity risk premium?

Answer 3

The risk premium can be earned long-term from an investment in the stock market. Economically, it is the premium earned by investors willing to take on the stock market risk compared to investing in a risk-free asset. Estimates on risk premiums come from Damodaran, historical data, Bloomberg, etc.

Question 4

Why do different investments show varying degrees of risk?

Answer 4

Higher risk, higher inflation, more fortunate than expected in some countries. Valuation levels increased, showing optimism.

Question 5

How can the risk of individual securities and of a portfolio of securities be measured?

Answer 5

By computing the variance or standard deviation of the returns because there is a difference between the expectation and the actual realization of any year.

Question 6

How does diversification reduce risk?

Answer 6

Diversification benefits, since wealth is not dependent on the specific (idiosyncratic) risk.
The only risk left is the market (systematic) risk
Correlation drives the portfolio benefits (covariance measures how much 2 random variables change together: if similar, + number and vice versa) (correlation coefficient measures strength and direction of the linear relationship between 2 variables)

Question 7

How to calculate portfolio returns

Answer 7

1. compute all individual variances
2. multiply all individual variances with their weights squared
3. compute the pairwise covariances of all stocks
4. multiply by the respective weights
5. sum up all weighted variances and weighted covariances

Question 8

What are the limits of diversification?

Answer 8

If we have a portfolio with N shares and the proportion of 1/N is invested in each share, as N increases, the portfolio variance converges to the average covariance. If the covariance is equal to zero, it would be possible to obtain a risk free portfolio

Question 9

What is the concept of “beta”?

Answer 9

With a diversified portfolio, all risk is market risk. The sensitivity of the stock-to-market movement is called beta, which is a measure of the market risk of the respective stock. Beta is the regression coefficient from a regression of the returns of a specific stock on the returns of the market portfolio.

Beta is the risk contribution of an asset to a diversified portfolio.

Beta is the appropriate measure to
- describe the level of risk of an investment
- compare different assets regarding their expected returns and beta exposure as a measure of risk contribution to the portfolio (wich are 2 dimensions of the CAPM capital asset pricing model)