Risk & Return

Question 1

The higher the risk undertaken, the more

Answer 1

ample the expected return–and conversely, the lower the risk, the more modest the expected return.

Question 2

The general progression in the risk-return spectrum is:

Answer 2

short-term debt, long-term debt, property, high-yield debt, and equity.

Question 3

When a firm makes a capital budgeting decision, they will wish, as a bare minimum, to

Answer 3

to recover enough to pay the increased cost of goods due to inflation.

Question 4

Risk aversion is a concept based on the

Answer 4

behavior of firms and investors while exposed to uncertainty to attempt to reduce that uncertainty.

Question 5

Political risk:

Answer 5

the potential loss for a company due to nonmarket factors as macroeconomic and social policies.

Question 6

Systematic risk:

Answer 6

the risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta.

Question 7

This risk and return tradeoff is also known as the

Answer 7

risk-return spectrum.

Question 8

There are various classes of possible investments, each with their own positions on the overall risk-return spectrum. The general progression is:

Answer 8

short-term debt, long-term debt, property, high-yield debt, and equity.

Question 9

For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value. Risk aversion can be thought of as having three levels:

Answer 9

Risk-averse or risk-avoiding
Risk-neutral
Risk-loving or risk-seeking

Question 10

Beta is also referred to as

Answer 10

financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset’s returns to market returns, its non-diversifiable risk, its systematic risk, or market risk.

Question 11

There are many types of financial risk, including:

Answer 11

asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.

Question 12

Financial risk is associated to the chances that

Answer 12

an investor might lose value in an investment. It is separated into different sources of decline.

Question 13

In the market crash of 2008, investors feared that

Answer 13

some home owners would default. It triggered a chain of events that shocked the whole world and left many people in bad financial situations.

Question 14

Variable Rate Mortgage:

Answer 14

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.

Question 15

The term “financial risk” is broad, but can be broken down into different categories to understand it better.

Answer 15

Interest rate risk, Credit risk or default risk, Liquidity risk, Market risk, Operational risk, Foreign investment risk, Model risk

Question 16

Interest rate risk is

Answer 16

the potential for loss that arises for bond owners from fluctuating interest rates.

Question 17

Credit risk or default risk, is

Answer 17

the risk that a borrower will default (or stop making payments).

Question 18

Liquidity risk is the

Answer 18

risk that an asset or security cannot be converted into cash in a timely manner. Some investments (i.e., stocks) can be sold immediately at the current market rate and others (i.e., houses) are subject to a much higher degree of liquidity risk.

Question 19

Market risk is

Answer 19

the term associated with the risk of losing value in an investment because of a decline in the market.

Question 20

Operational risk is another type of risk that deals with

Answer 20

the operations of a particular business. If you are invested in the Boston Red Sox, your operational risk might include the chance that starting pitchers and recent acquisitions won’t perform, that your manager will turn the clubhouse into a mess, or that ownership will not be able to execute a long-term strategy. Any of these risks might result in decreased revenues from ticket sales.

Question 21

Foreign investment risk involves

Answer 21

the risk associated with investments in foreign markets.

Question 22

Model risk involves

Answer 22

the chances that past models, which have been used to diversify away risk, will not accurately predict future models.

Question 23

Expected value is a concept that

Answer 23

helps investors assess the value of a potential investment based on different future outcomes and a probability for each outcome.

Question 24

Variance is

Answer 24

a statistical concept describing the range around expected return within which an investment return can be reasonably expected to fall.

Question 25

Three different asset classes—stocks, bonds, money markets—range from

Answer 25

aggressive, to moderate, to conservative. An investment that is aggressive typically features a higher expected return, but also a higher variance.

Question 26

Standard deviation:

Answer 26

The standard deviation of an investment is obtained by taking the square root of the variance. It has a more straightforward meaning than variance. It tells you that in a given year, you can expect an investment’s return to be one standard deviation above or below the average rate of return.

Question 27

Unsystematic risk:

Answer 27

Unsystematic or diversifiable risk is a term given to the portion of risk in a portfolio that can be diversified away by holding a pool of individual assets.

Question 28

An empirical example relating diversification to risk reduction:

Answer 28

In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3,290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains from diversification come for n ≤ 30 .

Question 29

Systematic risk:

Answer 29

systematic or non-diversifiable risk is a term given to the portion of risk in a portfolio that cannot be diversified away by holding a pool of individual assets and therefore commands a return in excess of the risk-free-rate.

Question 30

An investment portfolio has a 30% chance of earning $125,000 in a year, a 40% chance of earning $50,000, a 15% chance of earning nothing and 15% chance of losing $20,000. What is its expected return?

Answer 30

Expected return = (30% × $125,000) + (40% × $50,000) + (15% × 0) + (15% × –$20,000) = $54,500.

Question 31

A portfolio has $70,000 of bonds and $30,000 of stock. The bonds are 80% likely to have a 10% return and 20% likely to have a 0% return. The stock is 50% likely to have a 20% return and 50% likely to have a 10% loss. What is the expected return?

Answer 31

Expected return on bonds = (80% × 10%) + (20% × 0) = 8%
Expected return on stock= (50% × 20%) + (50% × –10%) = 5%
Overall expected return = ( 70/100 × 8%) + (30/100 × 5%) = 7.1%

Question 32

A company issues a bond with the provision that it may pay off the debt early. Which type of risk is this bond subject to?

Answer 32

Prepayment risk.

Question 33

The most common measure of risk in finance is the

Answer 33

Standard deviation is the most common measure of risk in finance.

Question 34

A portfolio is composed of 30% stock, 20% bonds, and 50% mutual funds. The stock is expected to have a 10% return, the bonds a 5% return and the mutual funds a 7% return. What is the expected return of the portfolio?

Answer 34

Expected return = (30% × 10%) + (20% × 5%) + (50% × 7%) = 7.5%.