Unit 4: Investment Risk and Portfolio Management Flashcards
The benefits of diversification decline to near zero when the number of securities held increases beyond:
A: 40
B: 10
C: 6
D: 4
A. 40
In practice, the benefits of diversificaiton become extremely small when more than about 20 to 30 different securities are held.
What is the CAPM equation?
What does it measure?
Capital Asset Pricing Model
- Measures how a particular security contributes to the risk and return of a diversified portfolio
- Quantifies the required return on an equity security by relating the security’s level of risk to the average return available in the market
- Based on time value of money and risk
What are the two basic types of investment risk?
Describe each…
Systematic Risk (market risk) - risk faced by all firms; also undiversifiable risk
Unsystematic Risk (company risk) - risk inherent in a particular investment security; also diversifiable risk
Equation for Rate of Return = ?
Define Credit risk
- Credit risk - risk that the issuer will default
Define Foreign exchange risk
- Foreign exchange risk - exchange rates will fluctuate
Interest rate risk
- Interest rate risk - value will fluctuate due to interest rate changes
Define Industry risk
- Industry risk - a change will affect securities issued by firms in a particular industry (e.g. oil prices on airplane industry)
Define Political risk
- Political risk - probability of loss from government actions like taxes or environmental regulations
Define Liquidity risk
- Liquidity risk - a security cannot be sold on short notice for market value
List and rank the financial instruments from lowest risk to highest risk…
Convertible preferred stock
Income bonds
Subordinated debentures
Second mortgage bonds
First mortgage bonds
Preferred stock
Common Stock
US Treasury bonds
- US Treasury Bonds
- First mortgage bonds
- Second mortgage bonds
- Subordinated debentures
- Inncome bonds
- Preferred stock
- Convertible preferred stock
- Common stock
Compute the expected rate of return:
Rate of return: S1 - 80%; S2 - (50)%
Probability: S1 - 60%; S2 - 40%
Answer: 28%
One way to measure risk is with the standard deviation (variance) of the distribution of an investment’s return.
What is the formula = ?
What is the coefficient of variation?
When is it useful?
What is the formula = ?
The coefficient of variation (CV) measures the risk per unit of return
Useful when the rates of return and standard deviations of two investments differ
*the lower the ratio, the better the risk-return tradeoff is
What is the expected rate of return on a portfolio?
The weighted average of the returns on the individual securities
What is covariance?
What is the formula = ?
A measure of two stocks’ mutual volatility
What is specific risk?
Risk associated with a specific investee’s operations: new products, patents, acquisitions, competitors’ activites, etc.
This can be potentially elimiated by diversification
Also called: diversifiable risk, unsystematic risk, residual risk, and unique risk
What is market risk?
The risk of the stock market as a whole
Also called undiversifiable risk and systematic risk
What is a beta coefficient?
A stock’s sensitivity to movements by the overall market.
Average risk stock: beta = 1.0; its returns are perfectly positively correlated with the market portfolio
Beta < 1.0: security less volatile than the market
Beta > 1.0: indicates a volatile security
If return increases 30% when the market return increases by 15%, security has a beta of 2.0
- How else may the beta for a security be calculated?
- What is the beta of a portolio equal to?
- May be calculated by dividing the covariance of the return on the market and the return on the security by the variance of the return on the market
- Beta of a portfolio is the weighted average of the betas of the individual securities
Draw the CAPM formula using:
Market Rate
Risk-free rate
Show Market risk premium
Show Risk free premium
Security market line
List two practical probelms with the use of CAPM
- It is hard to estimate the risk-free rate of return on projects under different economic environments
- The CAPM is a single-period model. It should not be use dfor projects lasting more than 1 year
What is the difference between the CAPM model and the APT model?
CAPM: a model that uses just one systematic risk factor to explain the asset’s return
APT: an asset’s return is a function of multiple systematic risk factors
- APT provides for a separate beta and a separate risk premium for each systematic risk factor in the model
What is the equation for APT?
i.e. 3-factor model
Advantage: APT can provide more exact information.
Disadvantage: APT is potentially more difficult to calculate
What is the Fama-French 3-factor model?
What is the equation?
An alternative to CAPM
Recognizes that two classes of stocks typically perform better than the stock market as a whole
- Small-cap stocks
- Stocks with high book-to-market ratio (value stocks)
What are two types of risk related to financial risk?
- Business risk: risk of an adverse outcome based on a change in the firms particular context (e.g. changes in input prices, consumer tastes, regulator environments)
- Financial risk: risk of an adverse outcome based on a change in the financial markets (e.g. changes in interest rates, investors’ desired rates of return)
A firm with high operating leverage carries a greater degree of risk because fixed costs must be covered regardless of the level of sales.
However, a firm is also able to expand production rapidly in times of higher product demand.
“operating leverage sensitivity”
The degree of a firm’s financial leverage increases as it uses more fixed costs (i.e. debt and preferred stock) in its financial structure
“financial leverage sensitivity”
What does the indifference curve measure?
The indifference curve represents combinations of portfolios having equal utility to the investor.
The steeper the slope of an indifference curve, the more risk averse an investor is
The higher the curve, the greater is the investor’s level of utility
What are two important decisions involved in managing a company’s portfolio?
- The amount of money to invest
- The securities in which to invest
What is hedging?
The process of using offsetting commitments to minimize or avoid the impact of adverse price movements.
- The purchase or sale of of a derivative is a hedge if it is expected to neutralize the risk of a recognized asset or liability, an unrecognized firm commitment, a forecasted transaction, etc.
- What are long hedges?
- What are short hedges?
- What is a natural hedge?
- Futures contracts that are purchased to protect against price increases
- Futures contracts that are sold to protect against price declines
- A method of reducing financial risk by investing in two different items whose performance tends to cancel each other out.
- What is duration hedging?
- What is the goal of duration hedging?
- Involves hedging interest rate risk.
- The goal of duration hedging is not to equate the duration of assets and duration of liabilities but for the following relationship to apply.
If the duration is positive, company exposed to rising interest rates
If the duration is negative, company exposed to falling interest rates
