Week 8

Question 1

What is beta?

Answer 1

Way to measure systematic risk

- Percentage change in an assets (stock) return GIVEN a 1% change in the market portfolio

Question 2

What are some names for unsystematic risk?

Answer 2

• Independent risk
• Firm-specific risk
• Idiosyncratic risk
• Unique risk
• Diversifiable risk
• Firm-specific VS systematic risk

Question 3

What are some names for systematic risk?

Answer 3

• Undiversifiable risk
• Market risk
• Common risks

Question 4

What is unsystematic risk?

Answer 4

risk factors that affect a large number of assets
- Examples: changes in GDP, inflation, interest rates, etc.
(due to firm specific news)

Question 5

What is systematic risk?

Answer 5

risks that affect a limited number of assets

due to market-wide news

Question 6

Formula for Total Risk

Answer 6

Total Risk = Systematic Risk + Unsystematic Risk

Question 7

Beta less than 1

Answer 7

has LESS systematic risk than the average firm

Question 8

Beta higher than 1

Answer 8

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

Question 9

Beta of zero

Answer 9

firm has no systematic risk

- does not react to market movement

Question 10

Negative beta

Answer 10

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

Question 11

standard deviation of a stock’s return (total risk)

Answer 11

is volatility

it captures market risk by beta and firm-specific risk

Question 12

What is market risk premium?

Answer 12

amount that the market risk exceeds the risk-free rate

Question 13

Formula for Market Risk Premium

Answer 13

Market Risk Premium = rm - rf

Market Risk Premium = rate of return expected from market (portfolio) - risk-free rate

Question 14

Higher beta means….

Answer 14

Higher beta: higher systematic risk: higher expected return

Question 15

What line do you get when a security’s excess returns is plotted against the market’s excess returns?

Answer 15

Beta

Question 16

What is capital asset pricing model (CAPM)?

Answer 16

formula for calculating the expected return of a security based on its systematic risk

Question 17

What happens when many stocks are combined in a large portfolio?

Answer 17

When many stocks are combined in a large portfolio, the firm-specific risks for each stock will average out and be diversified

Question 18

Can risks can be diversified out?

Answer 18

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

Question 19

If the diversifiable risk of stocks was compensated with an additional risk premium, then…

Answer 19

investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk

Question 20

How is risk premium of a security determined?

Answer 20

• 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

Question 21

What are the two steps for estimating the expected return?

Answer 21

• Measure the investment’s systematic risk

- Determine the risk premium required to compensate for that amount of systematic risk

Question 22

There is no way to reduce the volatility of the portfolio without lowering its ______

Answer 22

expected return

Question 23

Beta VS volatility

Answer 23

Volatility measures total risk (systematic plus unsystematic risk), while beta is a measure of only systematic risk.

Question 24

Estimating traded security’s expected return from ____

Answer 24

beta

Question 25

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

Answer 25

b) Systematic risk cannot be diversified away and investors are compensated for this risk

Question 26

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

Answer 26

A. beta

Question 27

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

Answer 27

D. security market line

Question 28

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.

Answer 28

B. risk-free rate.

Question 29

What is the term for risk associated with a single stock?

Answer 29

Unsystematic Risk