Section 6

Question 1

what do we call “optimal sequential decision making”?

Answer 1

Real Options

Question 2

Real Options but more simply are..?

Answer 2

options to modify projects

Question 3

What is CAPM??

Answer 3

Asset pricing theory which determines the equilibrium interest of assets as a function of its characteristics (its covariance)

Question 4

When the return on an investment is uncertain and its possible returns can be specified, its future returns can be represented by what?

Answer 4

Probability Distribution

Question 5

What does a probability distribution show?

Answer 5

probability that each possible return will occur

Question 6

What is the realized return?

Answer 6

sum of the dividend yield and the capital gain rate of return over a time period

Question 7

is there or is there not a clear positive relation between stocks average return and its volatility?

Answer 7

no, through ought history at least

Question 8

Do Large stocks tend to have high or low volatility?

Answer 8

low volatility

Question 9

do larger stocks make for long term non-risky investments?

Answer 9

no

Question 10

do all stocks have higher or lower risk and returns than would be predicted based on data for large portfolios?

Answer 10

higher risk and lower returns

Question 11

volatility explains risk well but fails when?

Answer 11

well in large portfolios, not so well with individual securities

Question 12

what is diversification?

Answer 12

averaging out independent risks in a large portfolio

Question 13

what is independent risk?

Answer 13

risk that is uncorrelated and independent for all risk assets - can be eliminated in a diversified portfolio

Question 14

what are common risks?

Answer 14

risk that affects the value of all risky assets, and cannot be eliminated in a diversified portfolio. eg, earthquake insurance policies in a portfolio of earth-quake policies in same geographic area.

Question 15

what are the two kinds of risk from investing in stock?

Answer 15

idiosyncratic and systematic risks

Question 16

what is idiosyncratic risk?

Answer 16

variation in stocks return due to firm specific news. this is also called firm specific, unsystematic, unique, or diversifiable risk

Question 17

what is systematic risk?

Answer 17

undiversifiable risk. risk that market wide news will simultaneously affect value of all assets

Question 18

how do we typically measure mathematically the systematic risk of a stock?

Answer 18

beta

Question 19

what is a firms cost of capital for a project?

Answer 19

expected return that its investors could earn on other securities with same risk and maturity

Question 20

a common assumption when determining cost of capital and risk, in relation to beta, is?

Answer 20

assume project has same risk as the firm, or other firms with similar assets

Question 21

what is the market risk premium?

Answer 21

difference between market portfolio’s expcted reutrn and the risk free interest rate

Question 22

with investments that have a beta different than 1, the expected return is given by which model?

Answer 22

CAPM

Question 23

what is excess return?

Answer 23

difference between average return for the investment and the average return for treasury bills, which are generally considered risk free

Question 24

what is common risk?

Answer 24

risk that affects values of all risky assets; cannot be eliminated by diversification

Question 25

what is independent risk?

Answer 25

risk that is uncorrelated and independent for all risky assets; can be eliminated in diversification

Question 26

what is diversification?

Answer 26

averaging out of independent risks in large portfolio

Question 27

what are common between firm specific, idiosyncratic, unsystematic, unique, or diversifiable risk?

Answer 27

risk arising from investing in a risky asset that is due to potential firm specific news and events

Question 28

what is systematic, undiversifiable, or market risk?

Answer 28

risk that market wide news and events will simultaneously affect value of all assets

Question 29

what is an efficient portfolio?

Answer 29

portfolio of risky assets that contains only systematic risk. changes in the value of this portfolio correspond to systematic shocks to the economy

Question 30

what is a market portfolio?

Answer 30

contains all risky assets in the market. standard to use s&p 500 portfolio as proxy for unobservable market portfolio of all risky assets

Question 31

how do we calculate the expected return of a stock?

Answer 31

weighted average of possible returns, where the weights correspond to the probabilities

Question 32

what are the two most common measures of risk, and how are they related to each other?

Answer 32

the two most common measures of risk of probability distrbution are variance and standard deviation. variance is expected squared deviation from the mean, and the standard deviation is the ware root of the variance

Question 33

how do we estimate the average annual return of an investment?

Answer 33

average of the realized returns for each year

Question 34

what is excess return?

Answer 34

difference between average return for the investment and the average return for treasury bills, a risk free investment

Question 35

do expected returns of a well diversified large portfolio of stocks appear to increase with volatility?

Answer 35

yes - there is positive relation between standard deviation of portfolios and their historical returns

Question 36

do expected returns for individual stocks appear to increase with volatility?

Answer 36

no- no clear relationship between volatility and return of individual stocks.

Question 37

what is the difference between common risk and independent risk?

Answer 37

common risk is the risk that is perfectly correlated across assets. independent risk is the risk that is uncorrelated and independent across assets

Question 38

explain why the risk premium of diversifiable risk is zero

Answer 38

because risk can be eliminated in a large portfolio. investors are not compensated for holding firm specific, or unsystematic, risk

Question 39

why is the risk premium of a security determined only by its systematic risk?

Answer 39

because investors cannot eliminate systematic risk they must be compensating for holding that risk. as a consequence, risk premium for a security depends on the amount of its systematic risk rather than its total risk

Question 40

what is the market portfolio?

Answer 40

contains shares of all stocks and securities in market

Question 41

how can you use securities beta to estimate cost of capital?

Answer 41

by determining the expected return using CAPM

Question 42

if a risky investment has a beta of zero, what should its cost of capital be according to the CAPM?

Answer 42

should equal risk free rate because it has no systematic risk