Topic 5 - Risk and Return

Question 1

returns of stocks and risk free assets

Answer 1

the future return of risk free assets are certain
the future return of stocks are not

Question 2

expected value (expected return)

Answer 2

a measure of centrality - basically the average value of the stock

Question 3

standard deviation (volatility)

Answer 3

a measure of dispersion -the square root of variance

Question 4

calculations for an individual asset (based on probabilities and returns)

Answer 4

1. expected return of an asset
   = sigma pi x Rij
2. the variance of an asset
   = sigma pj (Rij - mean)^2

Question 5

calculations for an individual asset (based on historical returns)

Answer 5

1. average return for asset i
2. variance of returns on asset i
3. standard error
4. 95% confidence interval

Question 6

limitations of historical returns

Answer 6

• its still an estimate. and we don’t know with 100% accuracy
• individual stocks tend to be more volatile than portfolios
• there is limited data available

Question 7

types of risk

Answer 7

stock prices and dividends fluctuate due to either firm specific news or market wide news. i.e idiosyncratic or systematic risk.

Question 8

idiosyncratic risk

Answer 8

fluctuations due to firm specific news.
this type of risk can be diversified away in a large portfolio

Question 9

systematic risk

Answer 9

fluctuations due to market wide news like changes in interest rates. this type of risk cannot be diversified away

Question 10

no arbitrage argument

Answer 10

1. the risk premium for diversifiable risk is 0
2. the risk premium solely depends on a security’s systematic risk

these imply that a stocks volatility, which is a measure of total risk, is not useful in determining the risk premium on individual securities

Question 11

market portfolio risk

Answer 11

a well diversified portfolio which would contain only systematic risk because idiosyncratic is diversified away.

Question 12

how do we measure systematic risk

Answer 12

by determining the sensitivity of a security’s returns to the returns on the market portfolio. this sensitivity is beta

Question 13

beta

Answer 13

beta represents the sensitivity of stock price when compared to the overall market.
it is used to assess the stocks risk or volatility compared to a broader market index like the S&P 500

Question 14

values of Beta

Answer 14

beta = 1, when the stock moves with the market
beta > 1, when the stock is more volatile than the market
beta < 1, when the stock is less volatile than the market

Question 15

market risk premium

Answer 15

the difference between the expected return and the risk free interest rate

Question 16

market portfolio expected return

Answer 16

we can derive this directly from economic scenarios and their probabilities. this will represent the weighted average return of the overall market.

Question 17

s-type firm expected return

Answer 17

we calculate this using CAPM, which adjusts market return to account for the firm specific beta.

we use the market expected return to calculate firm specific ones.