Risk and Return

Question 1

What is Return on investment?

Answer 1

A return is the amount received by an investor as compensation for taking on the risk of the investment:

Return on investment = Amount received - Amount invested

Question 2

What is Rate of return?

Answer 2

The rate of return is the return stated as a percentage of the amount invested:

Rate of return = Return on investment / Amount invested

Question 3

What are the two basic types of risk?

Answer 3

The two basic types of risk are:

1. Systematic risk (market risk)
2. Unsystematic risk (company risk)

Question 4

What is Systematic risk?

Answer 4

Systematic risk (also called market risk) is the risk faced by all firms. Changes in the economy as a whole (such as the business cycle) affect all players in a market

For this reason, systematic risk is sometimes referred to as undiversifiable risk. Since all investment securities are affected, this risk cannot be offset through portfolio diversification

Question 5

What is Unsystematic risk?

Answer 5

Unsystematic risk (also called company risk) is the risk inherent in a particular investment security. This type of risk is determined by the issuer’s industry, products, customer loyalty, degree of leverage, management competence, etc.

For this reason, unsystematic risk is sometimes referred to as diversifiable risk. Since individual securities are affected differently by economic conditions, this risk can be offset through portfolio diversification

Question 6

What is Credit risk?

Answer 6

Credit risk is the risk that the issuer of a debt security will default

This risk can be gauged by the use of credit-rating agencies

Question 7

What is Foreign exchange risk?

Answer 7

Foreign exchange risk is the risk that a foreign currency transaction will be affected by fluctuations in exchange rates

Question 8

What is Interest rate risk?

Answer 8

Interest rate risk is the risk that an investment security will fluctuate in value due to changes in interest rates

In general, the longer the time until maturity, the greater the degree of interest rate risk

Question 9

What is Industry risk?

Answer 9

Industry risk is the risk that a change will affect securities issued by firms in a particular industry (i.e. a spike in fuel prices will negatively affect the airline industry)

Question 10

What is Political risk?

Answer 10

Political risk is the probability of loss from actions of governments (i.e. from changes in tax laws, environmental regulations or from expropriation of assets)

Question 11

What is Liquidity risk?

Answer 11

Liquidity risk is the risk that a security cannot be sold on short notice for its market value

Question 12

What is the relationship between risk and return for a risk adverse investor?

Answer 12

Most serious investors are risk averse. They have a diminishing marginal utility for wealth. In other words, the utility of additional increments of wealth decreases

The utility of a gain for serious investors is less than the disutility of a loss of the same amount. Due to this risk aversion, risky securities must have higher expected return

Question 13

What is the relationship between risk and return for a risk neutral investor?

Answer 13

A risk neutral investor adopts an expected value approach because they regard the utility of a gain as equal to the disutility of a loss of the same amount. Thus, a risk-neutral investor has a purely rational attitude toward risk

Question 14

What is the relationship between risk and return for a risk-seeking investor?

Answer 14

A risk-seeking investor has an optimistic attitude toward risk. They regard the utility of a gain as exceeding the disutility of a loss of the same amount

Question 15

What are some financial instruments ranked from the lowest rate of return to the highest?

Answer 15

Ranked from the LOWEST rate of return to the HIGHEST (and thus the lowest risk to the highest), the following is a short list of widely available long-term financial instruments:

1. U.S. Treasury bonds
2. First mortgage bonds
3. Second mortgage bonds
4. Subordinated debentures
5. Income bonds
6. Preferred stock
7. Convertible preferred stock
8. Common stock

Note: These instruments also are ranked according to the level of security backing them. An unsecured financial instrument is much riskier than an instrument that is secured. Thus, the riskier asset earns a higher rate of return

Mortgage bonds are secured by assets, but common stock is completely unsecured. Accordingly, common stock will earn a higher rate of return than mortgage bonds

Question 16

What is the Expected rate of return?

Answer 16

The expected rate of return on an investment is determined using an expected value calculation. It is an average of the possible outcomes weighted according to their probabilities

= ∑ (Possible rate of return x Probability)

Question 17

What is Standard deviation?

Answer 17

Risk is the chance that the actual return on an investment will differ from the expected return. One way to measure risk is with the standard deviation (variance) of the distribution of an investment return

The standard deviation measures the tightness of the distribution and the riskiness of the investment

A large standard deviation reflects a broadly dispersed probability distribution (meaning the range of possible returns is wide). Conversely, the smaller the standard deviation, the tighter the probability distribution and the lower the risk

The greater the standard deviation, the riskier the investment

Question 18

What is the Coefficient of variation (CV)?

Answer 18

The coefficient of variation (CV) is useful when the rates of return and standard deviations of two investments differ. It measures the risk per unit of return:

CV = Standard deviation / Expected rate of return

The lower the ratio, the better the risk-return tradeoff is

Note: When comparing the risk of multiple investments, it is important to recognize that using the standard deviation alone can be misleading. Calculating the coefficient of variation gives you a better basis for comparison because it measures the risk per unit of return

Question 19

How should risk and return be evaluated?

Answer 19

Risk and return should be evaluated for a firm’s entire portfolio, not for individual assets. Thanks to the diversification effect, combining securities results in a portfolio risk that is less than the average of the standard deviations because the returns are imperfectly correlated

Question 20

What is the Correlation coefficient (r)?

Answer 20

The correlation coefficient (r) has a range from 1.0 to -1.0. It measures the degree to which any two variables (i.e. two stocks in a portfolio) are related

Question 21

What does perfect positive correlation mean?

Correlation coefficient concept

Answer 21

Perfect positive correlation (1.0) means that two variables always move together

Given perfect positive correlation, risk for a two-stock portfolio with equal investments in each stock would be the same as that for the individual assets

In practice, the existence of market risk makes perfect correlation nearly impossible. The normal range for the correlation of two randomly selected stocks is .50 to .70. The result is a reduction in (but NOT elimination) risk

Question 22

What does perfect negative correlation mean?

Correlation coefficient concept

Answer 22

Perfect negative correlation (-1.0) means that the two variables always move in the opposite direction

Given perfect negative correlation, risk would in theory be eliminated

Question 23

What is Covariance of a two-stock portfolio?

Answer 23

The correlation coefficient of two securities can be combined with their standard deviations to arrive at their covariance, a measure of their mutual volatility:

= correlation coefficient x std. deviation 1 x std. deviation 2

Question 24

What is asset allocation?

Answer 24

Portfolio theory concerns the composition of an investment portfolio that is efficient in balancing the risk with the rate of return of the portfolio

Asset allocation is a key concept in financial planning and money management. It is the process of dividing investments among different kinds of assets (i.e. stocks, bonds, real estate and cash) to optimize the risk-reward tradeoff based on specific situations and goals

The rationale is that the returns on different types of assets are not perfectly positively correlated. Asset allocation is especially useful for such institutional investors as pension fund managers, who have a duty to invest with prudence

Question 25

What is Specific risk?

Answer 25

Specific risk (also called diversifiable risk, unsystematic risk, residual risk and unique risk) is the risk associated with a specific investee’s operations: new products, patents, acquisitions, competitors’ activities, etc.

Specific risk is the risk that can be potentially eliminated by diversification

Question 26

What is the concept of relevant risk and how can diversification decrease this risk within a portfolio?

Answer 26

The relevant risk of an individual security held in a portfolio is its contribution to the overall risk of the portfolio. When much of a security’s risk can be eliminated by diversification, its relevant risk is low

In principle, diversifiable risk should continue to decrease as the number of different securities held increases. However, in practice the benefits of diversification become extremely small when more than about 20 to 30 different securities are held. Moreover, commissions and other transaction costs increase with greater diversification

Question 27

What is Market risk?

Answer 27

Market risk (also called undiversifiable risk and systematic risk) is the risk of the stock market as a whole

Some conditions in the national economy affect all business, which is why equity prices so often move together

Question 28

What is Beta coefficient (β)?

Answer 28

The effect of an individual security on volatility of a portfolio is measured by its sensitivity to movements by the overall market. This sensitivity is stated in terms of a stock’s beta coefficient

Question 29

What does a Beta coefficient of 1.0 mean?

Answer 29

An average-risk stock has a beta of 1.0 because its returns are perfectly positively correlated with those on the market portfolio (i.e. if the market return increases by 20%, the return on the security increases by 20%)

Question 30

What does a Beta coefficient of LESS than 1.0 mean?

Answer 30

A beta of less than 1.0 means that the security is LESS volatile than the market (i.e. if the market return increases by 20% and the security’s return increases only 10%, the security has a beta of .5

Question 31

What does a Beta coefficient of GREATER than 1.0 mean?

Answer 31

A beta over 1.0 indicates a volatile security (i.e. if the return increases 30% when the market return increases by 15%, the security has a beta of 2.0)

Question 32

How can Beta be calculated?

Answer 32

The beta for a security may also be calculated by dividing the covariance of the return on the market and the return on the security by the variance of the return on the market

Question 33

What is Beta the best measure of risk for an individual security held in a diversified portfolio?

Answer 33

Beta is the best measure of the risk of an individual security held in a diversified portfolio because it determines how the security affects the risk of the portfolio

The beta of a portfolio is the weighed average of the betas of the individual securities

Question 34

What is Portfolio insurance?

Answer 34

Portfolio insurance is a strategy of hedging a stock portfolio against market risk by selling stock index futures short of buying stock index put option

A stock index futures contract is an agreement to deliver the cash equivalent of a group of stocks on a specified date.

This cash equivalent equals a given stock index value (i.e. the S&P 500) times a cash amount. Thus, if the stock index falls (rises), a seller of stock index futures gains (losses) and a buyer loses (gains)

Question 35

What is the Capital Asset Pricing Model (CAPM)?

Answer 35

Investors want to reduce their risk and therefore take advantage of diversification by holding a portfolio of securities. In order to measure how a particular security contributes to the risk and return of a diversified portfolio, investors can use the capital asset pricing model (CAPM)

The CAPM quantifies the required return on an equity security by relating the security’s level of risk to the average return available in the market (portfolio)

Question 36

What are the components of CAPM?

Answer 36

The CAPM formula is based on the idea that the investor must be compensated for their investment in 2 ways: time value of money & risk

The time value component is the risk-free rate. It is the return provided by the safest investments (i.e. U.S. Treasury securities)

The risk component consist of:

The market premium (the return provided by the market over and above the risk-free rate) weighted by beta (measure of the security’s risk)

Question 37

What are issues related to using CAPM?

Answer 37

There are 2 practical problems with the use of CAPM:

1. It is hard to estimate the risk-free rate of return on projects under different economic environments
2. The CAPM is a single-period model. It should NOT be used for projects lasting more than 1 year

Question 38

What is Arbitrage Pricing Theory (APT)?

Answer 38

APT is based on the assumption that an asset’s return is a function of multiple systematic risk factors. In contrast, the CAPM is a model that uses just one systematic risk factor to explain the asset’s return. That factor is the expected return on the market portfolio (i.e. the marked-valued weighted-average return for all securities in the market)

The difference between actual and expected returns on an asset is attributable to systematic and unsystematic risks. Investors must be paid a risk premium to compensate for systematic (market) risk

APT provides for a separate beta and a separate risk premium for each systematic risk factor identified in the model. Examples of them many potential systematic risk factors are the gross domestic product (GDP), inflation & real interest rates

Question 39

What are advantages and disadvantages of the Arbitrage Pricing Theory (APT)?

Answer 39

An advantage of ATP is that is can provide more exact information. However, the disadvantage is that it is potentially more difficult to calculate

Question 40

What is the Fama-French Three-Factor Model?

Answer 40

The Fama-French three-factor model (another alternative to CAPM) recognizes that two classes of stocks typically perform better than the stock market as a whole. Those classes are small-cap stocks and stocks with a high-book-to-market ratio (also known as value stocks)

This model explains over 90% of the diversified portfolio’s returns, compared to the average 70% given by CAPM