week 19

Question 1

what are expected returns on a security

Answer 1

based on probabilities of possible outcomes
can be equated with average returns

Question 2

how do you calculate expected return

Answer 2

sum of (probability of event occurring x expected return on asset)

Question 3

what is a portfolio of securities

Answer 3

a collection of assets or securities
an assets risk and return impact and how it affects the risk and return of a portfolio
the risk and return trade-off for a portfolio, measured by portfolio expected return and standard deviation

Question 4

what is the expected return of a portfolio

Answer 4

weighted average of expected returns for each asset in the portfolio
can also be calculated by finding the portfolio returns in each possible state and computing expected returns

Question 5

what is the covariance of returns

Answer 5

measures how much the returns on two risky assets move together

Question 6

what does the correlation coefficient show

Answer 6

-1 - perfectly negatively correlated, two stocks can be combined to form a riskless portfolio
0 - uncorrelated
+1 - perfectly positively correlated, no risk reduction at all

Question 7

what is the difference between expected and unexpected returns

Answer 7

realised returns - generally not equal to expected returns
at any point in time an unexpected return can be positive or negative
overtime the average of the unexpected component is 0

Question 8

what are the components of returns

Answer 8

total return = expected return + unexpected return
unexpected return = systematic portion + unsystematic portion
total return = expected return + systematic portion + unsystematic portion

Question 9

what is systematic risk

Answer 9

risk factors that affect a large number of assets
also known as non-diversifiable risk, market risk or macro risk

Question 10

what is unsystematic risk

Answer 10

risk factors that affect a limited number of assets
risk that can be eliminated by combining assets into portfolios
also called unique, diversifiable, asset-specific or micro risk

Question 11

what is the principle of diversification

Answer 11

achieved by investing in several different assets or sectors with less than perfectly positive correlation
can substantially reduce risk without an equivalent reduction in expected returns
minimum level of risk that cannot be diversified away = systematic portion

Question 12

what is total risk

Answer 12

systematic risk + unsystematic risk
= stand alone risk
for well-diversified portfolios unsystematic risk is very small

Question 13

what is the systematic risk principle

Answer 13

there is a reward for bearing risk
there is no reward for bearing risk unnecessarily
the expected return on an asset depends only on that assets systematic or market risk
expected return = risk free rate + risk premium

Question 14

how do you measure systematic risk

Answer 14

measured by a stocks beta coefficient
shows contribution of the security to the overall riskiness of a portfolio
relevant for stocks held in well-diversified portfolios
𝛽 = 1 - average risk
𝛽 > 1 - riskier than average
𝛽 < 1 - less risky than average

Question 15

what is the risk premium

Answer 15

E(R) - rf
the higher the beta, the greater the risk premium should be

Question 16

what is the risk to reward ratio

Answer 16

slope of the line of the graph
E(Ra) - Rf / 𝛽a
in equilibrium ratio should be the same for all assets

Question 17

what should the risk to reward ratio be in market equilibrium

Answer 17

all assets and portfolios should have the same risk-to-reward ratio, each ratio should be equal to the market

Question 18

what is the capital asset pricing model

Answer 18

defines the relationship between risk and return for any asset
if an assets systematic risk is known, CAPM and SML can be used to determine expected return

Question 19

how do you calculate security market line (SML)

Answer 19

E(Ri) = rf + 𝛽(E(Rm) - rf)

Question 20

what factors affect required return

Answer 20

rf - measures the pure time value of money
E(Rm) - rf - measures reward for bearing systematic risk
Bi - amount of systematic risk