Topic 6 - Risk and Return

Question 1

What are the two methods to measure return?

Answer 1

Realised rate of return–the return an asset has already produced over a period of time.
The gain or loss realised by an investor on an investment is known as cash return.

Expected return–the return that an asset is expected to produce over some future
period of time.

Question 2

What is the risk of an investment?

Answer 2

The risk of an investment is the potential variability in future cash flows and can be measured statistically by the standard deviation of the returns on the related asset.

Question 3

What is risk premium?

Answer 3

The additional return expected from an investor for assuming the risk

Question 4

What is the standard deviation?

Answer 4

The standard deviation is a percentage measure of the dispersion, spread or variability of possible outcomes/rates of return

Question 5

Describe a portfolio

Answer 5

A portfolio is a collection of securities

Question 6

What does portfolio risk depend on?

Answer 6

Proportion of funds invested in each asset, referred to as the weights which must sum to 1 or 100% of the portfolio funds invested.

Risk associated with each asset in the portfolio as measured by the standard deviation of that asset’s returns.

Relationship between each asset in the portfolio with respect to risk as measured by the correlation of returns between each pair of assets.

Question 7

What is diversification?

Answer 7

Diversification relates to the addition of assets to a portfolio in order to reduce the standard deviation/risk, and by diversifying company-unique risk is said to be diversified away.

Question 8

What types of risk can be diversified away?

Answer 8

The diversifiable risk which can be eliminated by diversification is known as firm-specific risk, company unique risk or unsystematic risk.

Question 9

What is systematic risk?

Answer 9

The non-diversifiable risk which cannot be eliminated by diversification, no matter how many securities are included, is termed market-related risk, market risk or
systematic risk.

Question 10

What is the expected rate of return?

Answer 10

The average of all possible rates of return, where each possible return is weighted by the probability that it might occur.

Question 11

What is beta?

Answer 11

Beta measures risk in the context of the relationship between an investment’s returns and the market returns, and its measurement is time-dependent.

Question 12

What is a characteristic line?

Answer 12

The characteristic line relates the return on a company’s shares to some market index return. Beta is then the slope or gradient of that characteristic line.

Question 13

What is the security market line?

Answer 13

The security market line is a graphical representation of the risk-return trade off that exists in the
market. The line indicates the minimum acceptable rate of return for investors given a specific
level of risk. Since the security market line results from actual market transactions, the relationship
not only represents the risk-return preferences of investors in the market but also represents the
investors’ available opportunity set.
The security market line (SML) is a graph of the CAPM with the RRR on the vertical axis and beta on the horizontal axis; if a security plots above the SML it is underpriced and thus an attractive investment, whereas if it plots below the SML it is overpriced and an unattractive investment. However, the CAPM is not
without its critics.

Question 14

How does the expected-rate-of-return concept differ from that of the realised rate of return?

Answer 14

We call the gain or loss we actually experienced on a share during a period the realised rate of return for that period. However, the risk-return tradeoff that investors face is not based on realised rates of return; it is instead based on what the investor expects to earn on aninvestment in the future. We can think of the rate of return that will ultimately be realised from making a risky investment in terms of a range of possible return outcomes, much like the distribution of grades for a subject at the end of the semester. To describe this range of possible returns, investors use the average of the possibilities, which is known as the expected rate of return. To be more precise, the expected rate of return is the average of the possible returns, where each possible return is weighted by the probability that it occurs.

Question 15

Why is the volatility or variance in an investment’s rate of return a reasonable indication of the risk of the investment?

Answer 15

There are two methods financial analysts can use to quantify the variability of an investment’s returns. The first is the variance in investment returns and the second is the standard deviation, which is the square root of the variance. Both of these measures give
us an idea of the width of the distribution of possible outcomes—the wider the distribution, the more risk there is.

Question 16

Describe the relationship between the expected rate of return for an individual investment and the expected rate of return for a portfolio of several investments.

Answer 16

The expected rate of return for a portfolio of investments is simply a weighted average of
the expected rates of return of the individual investments in that portfolio. To calculate a portfolio’s expected rate of return, we weight each individual investment’s expected rate of return using the fraction of the portfolio which is invested in that particular investment. For instance, if you put half your money into BHP shares, with an expected rate of return of 12%, and the other half in Telstra shares with an expected rate of return of 8%, then we can calculate the expected rate of return of the portfolio as follows: (0.5 × 12%) + (0.5 × 8%) = 10%.

Question 17

Describe the relationship between correlation

and the risk and return of the portfolio

Answer 17

The correlation coefficient has no effect on the expected return of a portfolio, but the closer the correlation coefficient is to negative 1, the lower the risk.

Question 18

What is meant by the investors required rate of return?

Answer 18

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

Question 19

How do we measure the riskiness of a security such as a company share?

Answer 19

Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty
as to the exact outcome, the greater is the risk. Risk may be measured in terms of the standard deviation or by the variance, which is simply the standard deviation squared.

Question 20

What is the meaning of beta? How is it used to calculate R, the investor’s required rate of return?

Answer 20

Beta is a measure of the responsiveness of a firm’s returns as compared to market returns under the assumption of full diversification.
It is used to calculate the investor’s required rate of return by its inclusion into the CAPM, which expresses the required rate of return in terms of the risk free rate and the beta-adjusted market risk premium.