Risk and Return Flashcards
Investors demand compensation for ____ and ____.
time and risk
The higher the return… (pertaining to investors)
the more willing an investor is to take the deal.
Why can the probability distribution for a return on stock never be completely like a normal distribution?
It cannot go negative (you can’t lose more than you invested – limited liability!)
What is the equation for calculating the expected return of an asset?
ER = (probability#1)(return if #1 happens) + (probability#2)(return if #2 happens) …
The amount of dispersion in a graph of a probability distribution function is also…
the risk of a stock held by itself.
The more dispersion in the graph of a probability distribution function…
the MORE RISK.
What is the formula to calculate the variance?
(prob1)(outcome1 – ER)^2 +
(prob2)(outcome2 – ER)^2 …
The variance is the same as…
the standard deviation squared
The standard deviation is the same as…
the square root of the variance
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?
The SKI RESORT is better to invest in.
- lower variability
- higher expected return
Covariance helps to determine how…
two stocks move together.
Why is covariance important to consider for building a stock portfolio?
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.
What is the formula for calculating covariance?
(prob1) * (asset1outcome1 – ERa1) *
(asset2outcome1 – ERa2) …
Negative covariance tells you that the two stocks tend to move in…
OPPOSITE directions.
Positive covariance tells you that the two stocks tend to move in…
the SAME direction.
Covariance or Correlation Coefficient:
Which gives you both the magnitude and the direction of how two stocks move together?
covariance
Covariance or Correlation Coefficient:
Which gives you only the direction of how the two stocks move together?
correlation coefficient
What is the formula for calculating the correlation coefficient?
CorrXY = (CovXY) / (standdevX)(standdevY)
The correlation coefficient is always between…
-1.0 and 1.0
Most pairs of stocks have a _________ correlation coefficient.
positive
What is diversification theory?
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.
Why is the portfolio risk NOT a weighted average of the individual standard deviations of the stocks?
You have to take into account how the stocks move TOGETHER! (when one stock is successful, the other stock may be unsuccessful)
How can a portfolio be riskless?
All scenarios net out to the exact same monetary amount (losses and gains are offset in the exact same way each time).
As the covariance becomes more negative, the portfolio is considered (more/less) risky.
LESS risky.
