Risk & Return

Question 1

What is the expected return?

Answer 1

Historical or holding period or realized rate of return

Holding period = Price End of period + Dividend - Price Beginning of period

Question 2

What is the holding period rate of return?

Answer 2

Dollar gain (Price End + Div. - Price Beginning) / Price beginning of Period

Question 3

What are cash flows?

Answer 3

The expected benefits or returns, an investment generates come in the form of cash flows

Cash flows are used to measure returns

Question 4

What is the expected cash flow?

Answer 4

Is the weighted average of the possible cash flows outcomes such that the weights are the probabilities of the occurence of the various state of the economy

Expected Cash flow (x) = Sum(Pbi * CF)

Pb = probabilities of outcome i
CFi = cash flows in outcome i

Question 5

What isthe expected rate of return?

Answer 5

% expected return on 1000$ investment. Weighted average of all the possible returns, weighted by the probability that each return will occur.

Expected return (%)= Sum(PBi*ri)

Pb = probabilities of outcome i
r = expected % return in outcome i

Question 6

What are the three important questions concerning risk?

Answer 6

1. What is risk?
2. How do we measure risk?
3. Will diversification reduce the risk of portfolie?

Question 7

How can we define risk?

Answer 7

Risk refers to potential variability in future cash flows

The wider the range of possible future events that can occur, the greater the risk

Thus the return on common stock is more risky than returns from investing in savings account in a bank

Question 8

How do we measure risk?

Answer 8

compare the expected return

Standard deviation is one way to measure risk. It measures the volatility of portfolio returns
(Square root of the weighted average )

Question 9

What is a portfolio?

Answer 9

Combining several assets

Question 10

Which kind of risks exist?

Answer 10

two types of risk:

systematic risk (market risk): affects all firms e.g. war, tax change

unsystematic risk (company unique risk): CEO change etc.

Only non systematic risk can be reduced or eliminated through effective diversifiaction

Question 11

What means the correlation in portfolio management?

Answer 11

To reduce the risk

Two stocks are perfectly positively correlated -> diversification has no effect on risk

Two stocks are perfectly negatively correlated -> portfolio is perfectly diversified

Question 12

What should we consider while building our portfolio?

Answer 12

Pick assets that have negative or low correlation to attain diversification benefits

Question 13

What is the monthly holding return?

Answer 13

(Price end of month - price beginning of month) / price beginning of month

Question 14

How do we interprete beta?

Answer 14

Beta is the risk that remains for a company even after we have diversified our portfolio

Beta = 0 -> Stock has no systematic risk

Beta = 1 -> Systematic risk is equal to typical risk

Beta > 1 -> Systematic risk greater than typical stock

beta is usually between 0.6 and 1.6

Question 15

What is the Portfolio Beta?

Answer 15

indicates the percentage change on average of the portfolio for every 1% change in the general market

ß portfolio = Sum(wj * ßj)

wj = % invested in stock j
?j = beta of stock j

Question 16

What are other advantages of diversification?

Answer 16

The market rewards diversification

Through effective diversification, we can lower risk without sacrificing expected returns and we can increase expected returns without having to assume more

Question 17

What is Asset Allocation?

Answer 17

Diversifying among different kinds of asset types (treasury bills, bonds, stocks..)

Asset allocation decision has to be made today, payoff in the future will depend on the mix chosen before.

“Most important decision” while managing an investment portfolio

Reducing risk usually also reduces return.
Holding period also matters!

Question 18

What is the Inverstor’s Required Rate of Return?

Answer 18

is the minimum rate of return necessary to attract an investor to purchase or hold a security.

RRoR = risk free rate of return + risk premium

Question 19

What is the risk free rate?

Answer 19

The required rate of return or discount rate for risk-less investments.

Usually measured by U.S. treasurybill rate

Question 20

What is the risk premium?

Answer 20

Additional return we must expect to receive for assuming risk

When risk increases, we will demand additional expected returns

Question 21

What is the Capital Asset Pricing Model?

Answer 21

Equates the expected rate of return on a stock to the risk free rate plus a risk premium for the systematic risk.

Intuitive approach for thinking about the return that an investor should require on an investment.

Question 22

What is the CAPM Formula?

Answer 22

Required return = Risk free rate of return (rf) + beta * (required return on portfolio(rm) - risk free rate of return)

Example:
Market risk = 12%
Risk-free rate = 5%
Required return = 5% + Beta * (12% - 5%)

If Beta = 0 Required return = 5%
If Beta = 1 Required return = 12%
If Beta = 2 Required return = 19%

Question 23

What is the Security Market Line? (SML)

Answer 23

Is a graphic representation of the CAPM,where the line shows the appropiate required rate of return for a givens stocks systematic risk