Risk and return

Question 1

Understand the concept of risk aversion by investors

risk-averse investor

Answer 1

prepared to accept higher risk for higher expected return

required return on a particular investment increases with the investor’s perception of its risk

Question 2

3 types of investors

Answer 2

risk-taking

risk neutral

risk adverse

Question 3

Risk is measured in terms of how much a particular return

Answer 3

deviates from an expected return, measured by variance

Question 4

what does this show?

Answer 4

indifference curve

investor prefers B > A and B > C

investor would be indifferent between investments A and C.

Question 5

the gains from diversification are largest when

Answer 5

The gains from diversification are largest when there is negative correlation between asset returns, but they still exist when there is positive correlation between asset returns, provided that the correlation is less than perfect.

Question 6

These diversification benefits are greater

Answer 6

nthe more assets we incorporate into the portfolio.

Question 7

systematic and unsystematic risk

Answer 7

nSystematic risk (market-related risk or non-diversifiable risk) is the risk that is due to economy-wide factors.

nUnsystematic risk (diversifiable risk) is the risk that is unique to the firm and may be eliminated by holding a well-diversified portfolio

Question 8

Given risk aversion, each investor will want to hold a portfolio

a portfolio is efficient if

Answer 8

somewhere on the efficient frontier, but each investor may prefer a different point (risk adverse c.f. risk taking)

A portfolio is efficient if:

¡No other portfolio has a higher return for the same risk, or

¡No other portfolio has a lower risk for the same return.

Question 9

risk-averse investors will aim to hold portfolios that are efficient in that they

Answer 9

provide the highest expected return for a given level of risk.

Question 10

the only risk that remains in a well-diversified portfolio is

Answer 10

systematic risk

Question 11

for investors who diversify, the relevant measure of the risk of an individual asset is

Answer 11

is its systematic risk, which is usually measured by the beta of the asset

Question 12

security market line

draw

Answer 12

Question 13

Introduction of a risk-free asset allows the analysis to be

Answer 13

extended to model the relationship between risk and expected return for individual risky assets. The main result is the CAPM,