Section 1- Risk & Return Review

Question 1

What can the stock price be derived from

Answer 1

The net present value of all expected future dividends

Question 2

Does patient investor discount at a lower or higher rate?

Answer 2

At a lower rate (r)

Question 3

Does risk averse investors discount at a higher rate of dividend payout is uncertain?

Answer 3

Yes they almost always do

Question 4

Idiosyncratic risk

Answer 4

Independent risk due to firm specific news

Question 5

Systematic risk

Answer 5

Risk due to market-wide news

Question 6

Law of large numbers

Answer 6

If you hold 100 stocks (for example), a tiny of each, then pluses and minuses cancel each other out

Question 7

Diversification

Answer 7

Eliminate firm-specific variations, so reduces portfolio variance, for the same expected return.

Question 8

How can a rational investor hedge against idiosyncratic risk?

Answer 8

By making a pool of assets.

Question 9

What portfolio should everyone hold regardless of their taste for risk? How does it look for risk-averse people?

Answer 9

A combination of the efficient portfolio and the risk-free asset.
Risk-averse people invest less in the efficient portfolio, and more in the risk-free asset.

Question 10

What are the assumptions of CAPM?

Answer 10

1. Investors can trade all securities at competitive market price, without tax or transaction cost, and can lend & borrow at the risk-free rate.
2. Investors are rational, like expected return & dislike return volatility, and hold a diversified efficient portfolio to maximize their Sharpe Ratio.
3. Investors have homogenous beliefs.