Risk and Return

Question 1

Define Holding period return

Answer 1

Rate of return over given investment period. Its how much we get for each unit cash invested in security

Question 2

What are the two components of return

Answer 2

Income component is dividends and capital gains

HPR = Div Yield + Capital gains yield

Question 3

Define arithmetic average Return

Answer 3

Return earned in an average year over multiple years. What you earn in a typical year

Question 4

Define geometric average Return

Answer 4

Average compound Return each year over multiple years. What you actually earn. Assumes Y1 is reinvested

Question 5

Formula for geometric average return

Answer 5

[(1+R1) x (1+R2) x … x(I + Rt)]^1/t - 1

Question 6

Define risk free rate

Answer 6

Return earned with certainty - short term government debt securities usually used (short maturity)

Question 7

Define risk premium

Answer 7

Expected return in excess of that on risk free (reward)

Question 8

Define excess return

Answer 8

Additional return earned by moving from risk free investment to risky one

Question 9

What is the formula for expected return

Answer 9

Treasury bill(risk free) + risk premium

Question 10

What are the qualities of an efficient capital market

Answer 10

Security prices should reflect all available info and has competition - prices fluctuate with new info as investors reassess asset values based on that info

Question 11

What does the efficient market hypothesis state

Answer 11

Stock prices reflect all info. this means stock prices change unpredictably because information is unpredictable. - random walk

Question 12

What are some sources of information that might lead to stock prices changing?

Answer 12

Government figure on GDP
Drop in interest rates/ rise in sales
Result from latest arms control talks

Question 13

What is the formula for total return

Answer 13

R = E(R) + U where U is unexpected return

Question 14

Define delayed reaction on stock market

Answer 14

Suggests inefficent market - New information means prices partially adjust

Question 15

Define over reaction reaction on stock market

Answer 15

Suggests inefficent market - New information is overshooting price eventually correcting

Question 16

Name the three versions of efficient market hypothesis

Answer 16

Strong form EMH
Semi strong form EMH
Weak form EMH

Question 17

Explain the three versions of EMH

Answer 17

Strong form EMH - Stocks reflect all relevant info, even insider information
Semi strong form EMH - stocks reflect all public information already
Weak form EMH - Stocks reflect all information contained in history of trading - random component is due to new info

Question 18

Define technical analysis

Answer 18

Search for unpredictable patterns in stock prices

Question 19

Define fundamental analysis

Answer 19

Uses earnings, dividend prospects, expected interest rates, risk evaluation to determine the proper stock prices

Question 20

Define scenario analysis

Answer 20

Possible economic scenarios: specify liklihood HPR ex: examining recession and boom

Question 21

Define probability distribution

Answer 21

Possible outcomes with probabilities

Question 22

Define event study

Answer 22

Technique of empirical financial research enabling an observer to access the impact of an event on a firms stock price

Question 23

Define expected return

Answer 23

Return anticipates as return on a risky investment. Mean value of the distribution of realised returns - weighted average

Question 24

Define variance

Answer 24

Expected value of squared deviation from mean - average squared difference between actual return and average return

Question 25

Define portfolio

Answer 25

Group of assets held by investor

Question 26

Define portfolio weight

Answer 26

% of portfolio’s total value in a particular asset

Question 27

Define market risk/systematic risk

Answer 27

Risk attributable to market wide risk sources and remains even after extensive diversification is systematic risk or market risk

Question 28

Define non systematic risk

Answer 28

Diversifiable, firm specific risk can be eliminated

Question 29

What does the diversification principle mean

Answer 29

Means spreading an investment across assets (portfolios) eliminates some but not all of risk - some is systematic. Adding more stock to portfolios means deviation from expected return decreases too

Question 30

What does systematic risk principle tell us about return on an asset

Answer 30

Expected return on asset depends only on its systematic risk as the unsystematic risk can be eliminated at no cost - hence there is no reward for bearing it

Question 31

Define Beta coefficent

Answer 31

Measures sensitivity to market risk - amount of systematic risk in a risky asset relative to that in an average risky asset

Question 32

What is the difference between risk premium and excess return

Answer 32

risk premium- expected return

excess return - realised return

Question 33

If B<1 what does this mean

Answer 33

Stock has low volatility - defensive stock ex: coca cola

Question 34

If B>1 what does this mean

Answer 34

Stock has greater volatility to fluctuating returns - aggressive/cyclical stock ( bought more in boom and less in recession)

Question 35

If B=1 what does this mean

Answer 35

Market portfolio beta

Question 36

If B=0 what does this mean

Answer 36

Beta of risk free asset

Question 37

Define market risk premium

Answer 37

Difference between expected return on market and interest rate on the risk free asset

Question 38

formula for risk premium on an asset

Answer 38

E(Ri) - Rf

Question 39

In equilibrium what should reward to risk ratio be?

Answer 39

same for all assets

reward to risk for market = reward to risk for asset

Question 40

What is principle of risk to reward ratio in equilibrium called?

Answer 40

Capital pricing model

Question 41

Give the equation of the security market line and details of the graph

Answer 41

E(Ri) = Rf +[E(Rm)- Rf] x Bi - CAPM

Slope is market risk premium!

Question 42

What is the fundamental relationship between beta and expected return

Answer 42

assets must have same reward to risk ratio and must plot all on the same straight line

Question 43

If assets plot above/ below SML what does this mean?

Answer 43

Above - Unpriced (current price too low)

Below - Overpriced (current price too high)