Week 8 Flashcards
What is beta?
Way to measure systematic risk
- Percentage change in an assets (stock) return GIVEN a 1% change in the market portfolio
What are some names for unsystematic risk?
- Independent risk
- Firm-specific risk
- Idiosyncratic risk
- Unique risk
- Diversifiable risk
- Firm-specific VS systematic risk
What are some names for systematic risk?
- Undiversifiable risk
- Market risk
- Common risks
What is unsystematic risk?
risk factors that affect a large number of assets
- Examples: changes in GDP, inflation, interest rates, etc.
(due to firm specific news)
What is systematic risk?
risks that affect a limited number of assets
due to market-wide news
Formula for Total Risk
Total Risk = Systematic Risk + Unsystematic Risk
Beta less than 1
has LESS systematic risk than the average firm
Beta higher than 1
have MORE systematic risk than the average firm
- When the market goes up, the company goes up more than the market
- When market goes down it falls further
Beta of zero
firm has no systematic risk
- does not react to market movement
Negative beta
firm has a negative risk premium
- Return is less than the risk-free rate
- Insurance for when the market goes bad
- It will do well if the rest of the market crashes
standard deviation of a stock’s return (total risk)
is volatility
it captures market risk by beta and firm-specific risk
What is market risk premium?
amount that the market risk exceeds the risk-free rate
Formula for Market Risk Premium
Market Risk Premium = rm - rf
Market Risk Premium = rate of return expected from market (portfolio) - risk-free rate
Higher beta means….
Higher beta: higher systematic risk: higher expected return
What line do you get when a security’s excess returns is plotted against the market’s excess returns?
Beta
What is capital asset pricing model (CAPM)?
formula for calculating the expected return of a security based on its systematic risk
What happens when many stocks are combined in a large portfolio?
When many stocks are combined in a large portfolio, the firm-specific risks for each stock will average out and be diversified
Can risks can be diversified out?
When firms carry both types of risk, only the unsystematic risk will be diversified when many firm’s stocks are combined into a portfolio
- Volatility will decline until only the systematic risk remains
If the diversifiable risk of stocks was compensated with an additional risk premium, then…
investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk
How is risk premium of a security determined?
- Risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk
- stock’s volatility, which is a measure of total risk (systematic risk + diversifiable risk) is not useful in determining the risk premium that investors will earn
What are the two steps for estimating the expected return?
- Measure the investment’s systematic risk
- Determine the risk premium required to compensate for that amount of systematic risk
There is no way to reduce the volatility of the portfolio without lowering its ______
expected return
Beta VS volatility
Volatility measures total risk (systematic plus unsystematic risk), while beta is a measure of only systematic risk.
Estimating traded security’s expected return from ____
beta
Which statement best describes systematic risk?
a) Systematic risk can be diversified away and investors are not compensated for this risk
b) Systematic risk cannot be diversified away and investors are compensated for this risk
b) Systematic risk cannot be diversified away and investors are compensated for this risk
Which one of the following measures the amount of systematic risk present in a particular risky asset relative to the systematic risk present in an average risky asset? A. beta B. reward-to-risk ratio C. risk ratio D. standard deviation E. price-earnings ratio
A. beta
Which one of the following is a positively sloped linear function that is created when expected returns are graphed against security betas? A. reward-to-risk matrix B. portfolio weight graph C. normal distribution D. security market line E. market real return
D. security market line
The expected risk premium on a stock is equal to the expected return on the stock minus the: A. expected market rate of return. B. risk-free rate. C. inflation rate. D. standard deviation. E. variance.
B. risk-free rate.
What is the term for risk associated with a single stock?
Unsystematic Risk
