Risk and Return

Question 1

Investors demand compensation for ____ and ____.

Answer 1

time and risk

Question 2

The higher the return… (pertaining to investors)

Answer 2

the more willing an investor is to take the deal.

Question 3

Why can the probability distribution for a return on stock never be completely like a normal distribution?

Answer 3

It cannot go negative (you can’t lose more than you invested – limited liability!)

Question 4

What is the equation for calculating the expected return of an asset?

Answer 4

ER = (probability#1)(return if #1 happens) + (probability#2)(return if #2 happens) …

Question 5

The amount of dispersion in a graph of a probability distribution function is also…

Answer 5

the risk of a stock held by itself.

Question 6

The more dispersion in the graph of a probability distribution function…

Answer 6

the MORE RISK.

Question 7

What is the formula to calculate the variance?

Answer 7

(prob1)(outcome1 – ER)^2 +
(prob2)(outcome2 – ER)^2 …

Question 8

The variance is the same as…

Answer 8

the standard deviation squared

Question 9

The standard deviation is the same as…

Answer 9

the square root of the variance

Question 10

Amusement Park:
Expected Return: 7%
Standard Deviation: 14.18%

Ski Resort:
Expected Return: 9%
Standard Deviation: 11.14%

Which is better to invest in and why?

Answer 10

The SKI RESORT is better to invest in.

• lower variability
• higher expected return

Question 11

Covariance helps to determine how…

Answer 11

two stocks move together.

Question 12

Why is covariance important to consider for building a stock portfolio?

Answer 12

DIVERSIFICATION! You want to have stocks with a negative covariance because they move in opposite directions, when one goes down the other will go up.

Question 13

What is the formula for calculating covariance?

Answer 13

(prob1) * (asset1outcome1 – ERa1) *
(asset2outcome1 – ERa2) …

Question 14

Negative covariance tells you that the two stocks tend to move in…

Answer 14

OPPOSITE directions.

Question 15

Positive covariance tells you that the two stocks tend to move in…

Answer 15

the SAME direction.

Question 16

Covariance or Correlation Coefficient:
Which gives you both the magnitude and the direction of how two stocks move together?

Answer 16

covariance

Question 17

Covariance or Correlation Coefficient:
Which gives you only the direction of how the two stocks move together?

Answer 17

correlation coefficient

Question 18

What is the formula for calculating the correlation coefficient?

Answer 18

CorrXY = (CovXY) / (standdevX)(standdevY)

Question 19

The correlation coefficient is always between…

Answer 19

-1.0 and 1.0

Question 20

Most pairs of stocks have a _________ correlation coefficient.

Answer 20

positive

Question 21

What is diversification theory?

Answer 21

By owning many stocks, when one stock does poorly it is likely that another stock in the portfolio may do well and offset the loss.

Question 22

Why is the portfolio risk NOT a weighted average of the individual standard deviations of the stocks?

Answer 22

You have to take into account how the stocks move TOGETHER! (when one stock is successful, the other stock may be unsuccessful)

Question 23

How can a portfolio be riskless?

Answer 23

All scenarios net out to the exact same monetary amount (losses and gains are offset in the exact same way each time).

Question 24

As the covariance becomes more negative, the portfolio is considered (more/less) risky.

Answer 24

LESS risky.