Unit 4: Investment Risk and Portfolio Management

Question 1

The benefits of diversification decline to near zero when the number of securities held increases beyond:

A: 40

B: 10

C: 6

D: 4

Answer 1

A. 40

In practice, the benefits of diversificaiton become extremely small when more than about 20 to 30 different securities are held.

Question 2

What is the CAPM equation?

What does it measure?

Answer 2

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

Question 3

What are the two basic types of investment risk?

Describe each…

Answer 3

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

Question 4

Equation for Rate of Return = ?

Answer 4

Question 5

Define Credit risk

Answer 5

1. Credit risk - risk that the issuer will default

Question 6

Define Foreign exchange risk

Answer 6

1. Foreign exchange risk - exchange rates will fluctuate

Question 7

Interest rate risk

Answer 7

1. Interest rate risk - value will fluctuate due to interest rate changes

Question 8

Define Industry risk

Answer 8

1. Industry risk - a change will affect securities issued by firms in a particular industry (e.g. oil prices on airplane industry)

Question 9

Define Political risk

Answer 9

1. Political risk - probability of loss from government actions like taxes or environmental regulations

Question 10

Define Liquidity risk

Answer 10

1. Liquidity risk - a security cannot be sold on short notice for market value

Question 11

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

Answer 11

1. US Treasury Bonds
2. First mortgage bonds
3. Second mortgage bonds
4. Subordinated debentures
5. Inncome bonds
6. Preferred stock
7. Convertible preferred stock
8. Common stock

Question 12

Compute the expected rate of return:

Rate of return: S1 - 80%; S2 - (50)%

Probability: S1 - 60%; S2 - 40%

Answer 12

Answer: 28%

Question 13

One way to measure risk is with the standard deviation (variance) of the distribution of an investment’s return.

What is the formula = ?

Answer 13

Question 14

What is the coefficient of variation?

When is it useful?

What is the formula = ?

Answer 14

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

Question 15

What is the expected rate of return on a portfolio?

Answer 15

The weighted average of the returns on the individual securities

Question 16

What is covariance?

What is the formula = ?

Answer 16

A measure of two stocks’ mutual volatility

Question 17

What is specific risk?

Answer 17

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

Question 18

What is market risk?

Answer 18

The risk of the stock market as a whole

Also called undiversifiable risk and systematic risk

Question 19

What is a beta coefficient?

Answer 19

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

Question 20

1. How else may the beta for a security be calculated?
2. What is the beta of a portolio equal to?

Answer 20

1. 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
2. Beta of a portfolio is the weighted average of the betas of the individual securities

Question 21

Draw the CAPM formula using:

Market Rate

Risk-free rate

Show Market risk premium

Show Risk free premium

Security market line

Answer 21

Question 22

List two practical probelms with the use of CAPM

Answer 22

1. It is hard to estimate the risk-free rate of return on projects under different economic environments
2. The CAPM is a single-period model. It should not be use dfor projects lasting more than 1 year

Question 23

What is the difference between the CAPM model and the APT model?

Answer 23

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

Question 24

What is the equation for APT?

Answer 24

i.e. 3-factor model

Advantage: APT can provide more exact information.

Disadvantage: APT is potentially more difficult to calculate

Question 25

What is the Fama-French 3-factor model? What is the equation?

Answer 25

An alternative to CAPM Recognizes that two classes of stocks typically perform better than the stock market as a whole 1. Small-cap stocks 2. Stocks with high book-to-market ratio (value stocks)

Question 26

What are two types of risk related to financial risk?

Answer 26

1. 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) 2. 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)

Question 27

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"

Question 28

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"

Question 29

What does the indifference curve measure?

Answer 29

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

Question 30

What are two important decisions involved in managing a company's portfolio?

Answer 30

1. The amount of money to invest 2. The securities in which to invest

Question 31

What is hedging?

Answer 31

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.

Question 32

1. What are long hedges? 2. What are short hedges? 3. What is a natural hedge?

Answer 32

1. Futures contracts that are purchased to protect against price increases 2. Futures contracts that are sold to protect against price declines 3. A method of reducing financial risk by investing in two different items whose performance tends to cancel each other out.

Question 33

1. What is duration hedging? 2. What is the goal of duration hedging?

Answer 33

1. Involves hedging interest rate risk. 2. 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