Risk Return

Question 1

3 different investments

Answer 1

1. A portfolio of Treasury Bills (“Bills
2. A portfolio of U.S. government bonds (“Bonds”)
3. A portfolio of U.S. common stocks (“Stocks”)

Question 2

Focus on nominal value

Answer 2

The value measured in current prices, without adjusting for inflation. It’s the “raw” number

Question 3

Consumer Price Index (CPI)

Answer 3

purchasing power by averaging the prices of goods and services in the consumption basket of an average urban family of four

Question 4

The annual percentage change in CPI

Answer 4

is used as a measure of
inflation by both researchers and practitioners

Question 5

The classical theory of interest rates was developed by who?

Answer 5

Fisher (1907)

Question 6

Classical theory of interest rate: Formula

Answer 6

nominal r = real r x expected inflation

Approximate
1 + r nominal = (1 + r eal) x (1 +i)

Question 7

Inflation measures what?

Answer 7

the change of an economy’s price level (goods
and services)

Question 8

The real interest rate: definition

Answer 8

The theoretical rate you pay when you
borrow money (or receive when you lend money)

Question 9

The real interest rate: characteristic

Answer 9

• The real interest rate cannot be observed; it can only be derived.
• Real interest rates can be negative (due to low nominal interest rates and significant inflation).
• The real interest rate is theoretically somewhat stable.

Question 10

Drivers of real interest rates

Answer 10

• Real interest rates are affected by the monetary policy of central banks.
• People’s willingness to save (supply of capital)
• Opportunities for productive investments (demand side)

Question 11

Equity risk premium: definition

Answer 11

the risk premium that can be earned in the long-term from an investment in the stock market

–> premium earned by investors willing to take
on the stock market risk as compared to an investment in a risk-free asset

Question 12

Where do estimates of the risk premium come from?

Answer 12

• Damodaran
• Historical data
• Ibbotson/Morningstar
• Brealey, Myers, and Allen and other books
• Bloomberg / Analyst forecasts
• Ferndandez et al. surveys

Question 13

What drives the equity risk premium? And why does it differ so much across countries?

Answer 13

• Higher risk in some countries
• Higher inflation in some countries (these are nominal values)
• Ex-post some countries might have been more fortunate than could have been expected
• Valuation levels increased (e.g., based on dividend yield or M/B- ratio) which could indicate optimism and result in a lower equity risk premium in the future

Question 14

variance or standard deviation

Answer 14

The realized stock returns are by no means equal to or close to their historical average value but vary a lot across years (and months,
weeks, days…)
–> measure this “spread” of returns
–> important difference between the expectation and actual realization

Question 15

Variance: Calculation

Answer 15

1 / N - 1 (rmt - rm)^2

Question 16

Standard deviation: Calculation

Answer 16

the square root of the variance

Question 17

Diversification benefits: stocks

Answer 17

By holding a variety of stocks, the negative performance of some can be offset by the positive performance of others

Question 18

f you invest all your money into one stock,
your wealth will entirely depend on the specific ?

Answer 18

risk of this one company (i.e., “putting all eggs in one basket”)

Question 19

The only risk left (which you cannot diversify away): what is it?

Answer 19

The market (or systematic) risk

Question 20

covariance

Answer 20

a measure of how much two random variables
change together. If the greater values of one variable mainly correspond with the greater values of the other variable, and the same holds for the smaller values, i.e., the variables tend to show similar behavior, the covariance is a positive number. If the variables show opposite behavior, the covariance is a negative number

Question 21

correlation coefficient

Answer 21

measures the strength and direction of the linear relationship between two variables. It is a standardized version of the covariance and is bound to a (-1, 1)
interval

Question 22

Calculating the expected return of a portfolio of stocks

Answer 22

It is the weighted average of the expected returns of the individual securities in the portfolio

Question 23

The portfolio risk (variance): calculation

Answer 23

is the sum of all individual variances multiplied by their weights squared and all covariances multiplied by the weights of both respective stocks

1/N x average variance + (1 - 1/N) x average variance

Question 24

When N increases what does happen for the portfolio variance?

Answer 24

the portfolio variance converges to the average covariance

Question 25

If the average covariance is equal to zero, it would be possible to obtain?

Answer 25

a risk-free portfolio

Question 26

The portfolio is market risk when ?

Answer 26

Once you have a diversified portfolio (i.e., no specific risk), all risk in the portfolio is market risk

Question 27

beta (β) : what does it mean?

Answer 27

The sensitivity of the stock to market movements --> is a measure of market risk of the respective stock Beta is the regression coefficient from a regression of the returns of a specific stock on the returns of the market portfolio Beta is the risk contribution of an asset to a diversified portfolio (more precisely to the market portfolio)

Question 28

Beta : calculation

Answer 28

Cov (Ri, Rm) / Var (Rm)

Question 29

The beta of a portfolio is what?

Answer 29

The weighted average of the betas of the individual stocks within the portfolio

Question 30

The beta of a well-diversified portfolio can be define as what?

Answer 30

Total Risk