FINC 331-WEEK 5: Stocks
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Ch8-introduction-to-risk-and-return.pdf
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Introduction to
Risk and Return
Understanding Return
Portfolio Considerations
The Impact of News of Expected Returns
Risk
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Implications Across Portfolios
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Introduction to
Risk and Return
(continued)
Diversification
Understanding the Security Market Line
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• Expected Return
• Variance
Understanding Return
Introduction to Risk and Return > Understanding Return
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• In order to make investment decisions, investors often estimate the expected
return of a potential investment.
• Expected value is a concept that the helps investors assess the value of a
potential investment based on different future outcomes and a probability for each
outcome.
• Once you have categories for different scenario's, along with probabilities and
returns in each scenario, you then calculate your expected return by multiplying
each probability by it's respective outcome and adding these all together.
Expected Return
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Introduction to Risk and Return > Understanding Return
• Any investment should be made taking time considerations and risk tolerance into
account. If there is a specific deadline for when the investment needs to be
matured (i.e. to generate retirement income, pay for a down payment on a house,
college tuition) then caution is required.
• Three different asset classes -- stocks, bonds, money markets -- range from
aggressive, to moderate, to conservative. An investment that is aggressive
typically features a higher expected return, but also a higher variance.
• Variance is calculated by calculating an expected return and summing a weighted
average of the squared deviations from the mean return.
Variance
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How much do investors want to pay to have to
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Introduction to Risk and Return > Understanding Return
• Portfolio Diversification and Weighting
• Implications for Expected Returns
• Implications for Variance
Portfolio Considerations
Introduction to Risk and Return > Portfolio Considerations
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• Diversification is the idea of spreading a portfolio across different classes of
investments with a target weight attached to each class.
• Modern portfolio theory is the idea that for any investment objective, there is an
optimal mix of investments that can maximize expected return subject to a
specific risk threshold.
• Systemic risk is the risk that applies to a particular market or industry. It cannot be
diversified away. Specific risk is the risk that applies to one particular investment
within a market and it can be diversified away.
Portfolio Diversification and Weighting
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Diversified Portfolio
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Introduction to Risk and Return > Portfolio Considerations
• Asset allocation is a theory of designing a portfolio that achieves a weighting
scheme with a target mix of different asset classes that is suitable to the time
frame and risk tolerance of the investor.
• The principals that support the theory of asset allocation are the cyclical nature of
investments within a particular class of assets and weaker or even negative
correlations that often exist across asset classes.
• When you re-balance your portfolio after it has deviated from the original target
mix, you are selling classes that have relatively appreciated in order to buy those
which have relatively depreciated.
• If you believe that markets go in cycles, you should believe in selling assets that
have relatively appreciated and buying those which have relatively depreciated.
Implications for Expected Returns
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Average Returns for Different Weighting
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Introduction to Risk and Return > Portfolio Considerations
• Portfolio managers often target a mix of assets across different categories that
maximize potential return and limit specific risk.
• Portfolio managers choose from many more classes of assets than the two that
have been used primarily for this chapter.
• With historical data, powerful software and a proficient financial analyst, a
correlation matrix can be produced that helps portfolio managers make
investment decisions that will limit the portfolio's overall risk and exposure to
market downturns.
Implications for Variance
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Illustration of Modern Portfolio Theory
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Introduction to Risk and Return > Portfolio Considerations
• Surprises and Returns
• Announcements, News, and Returns
The Impact of News of Expected Returns
Introduction to Risk and Return > The Impact of News of Expected Returns
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• Surprise announcements that come from a company, its competition, or a supplier
or customer can affect the long run value of a stocks and bonds related to that
company.
• These announcements will often concern earnings, stages in a product
development cycle (FDA approval of a drug) or corporate structure changes (the
acquisition of a competitor) and can move a company's outlook positively or
negatively.
• When the news is generally seen as positive, a company's equity and debt
become more valuable on the secondary market, and its stock price will rise and
the effective yield on its debt instruments will fall.
Surprises and Returns
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World countries Standard & Poor's ratings
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Introduction to Risk and Return > The Impact of News of Expected Returns
• A company that is publicly traded must announce its earnings reports quarterly.
When the report matches analysts' expectations, the stock's price will not be
greatly affected. When it announces a report that is unexpected, it can affect the
stock price of a competitor or supplier as well.
• Beta is a metric used to signal the risk in a particular stock. Stocks with high beta
values fluctuate more on a day-to-day basis than those with lower beta values.
• Analysts constantly assess the health of public companies to assess the value of
its equity and debt instruments, and their outlook affects stock and bond prices in
secondary markets.
Announcements, News, and Returns
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Volatility begets volatility
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Introduction to Risk and Return > The Impact of News of Expected Returns
• Types of Risk
• Measuring Risk
Risk
Introduction to Risk and Return > Risk
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• Financial risk is associated to the chances that an investor might lose value in an
investment. It is separated into different sources of decline.
• Often the risks interact with each other and ultimately shock causes panic. Many
of the worst market crashes have been a result of widespread speculation and not
the devaluation of that asset itself.
• In the market crash of 2008, investors feared that some home owners would
default. It triggered a chain of events that shocked the whole world and left many
people in bad financial situations.
Types of Risk
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Introduction to Risk and Return > Risk
• The general progression in the risk-return spectrum is: short-term debt, long-term
debt, property, high-yield debt, and equity.
• When a firm makes a capital budgeting decision, they will wish, as a bare
minimum, to recover enough to pay the increased cost of goods due to inflation.
• Risk aversion is a concept based on the behavior of firms and investors while
exposed to uncertainty to attempt to reduce that uncertainty.
• Beta is a measure firms can use in order to determine an investment's return
sensitivity in relation to overall market risk.
Measuring Risk
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Inflation
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Introduction to Risk and Return > Risk
• Calculating Expected Portfolio Returns
• Portfolio Risk
• Beta Coefficient for Portfolios
Implications Across Portfolios
Introduction to Risk and Return > Implications Across Portfolios
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• To calculate the expected return of a portfolio, you need to know the expected
return and weight of each asset in a portfolio.
• The figure is found by multiplying each asset's weight with its expected return,
and then adding up all those figures at the end.
• These estimates are based on the assumption that what we have seen in the past
is what we can expect in the future, and ignores a structural view on the market.
Calculating Expected Portfolio Returns
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A Fruitful Portfolio
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Introduction to Risk and Return > Implications Across Portfolios
• Portfolios that are efficient investments are those that effectively diversify the
underlying risk away and price their investment efficiently.
• Portfolio risk takes into account the risk and weight of each individual position and
also the co-variances across different positions.
• To calculate the risk of a portfolio, you need each asset's variance along with a
matrix of cross-asset correlations.
Portfolio Risk
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Variance of any portfolio
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Introduction to Risk and Return > Implications Across Portfolios
• In individual stocks, a beta coefficient compares how much a particular stock
fluctuates in value on a day-to-day basis.
• A beta coefficient for a portfolio of assets measures how that portfolio value
changes compared to a benchmark, like the S&P 500. A value of 1 suggests that
it fluctuates as much as the index and in the same direction.
• A beta coefficient of less than 1 suggests a portfolio that fluctuates less than the
benchmark. A negative beta is an indication that a portfolio moves in the opposite
direction of its benchmark.
Beta Coefficient for Portfolios
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Calculating Beta
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Introduction to Risk and Return > Implications Across Portfolios
• Impact of Diversification on Risk and Return: Unsystematic Risk
• Impact of Diversification on Risk and Return: Systematic Risk
Diversification
Introduction to Risk and Return > Diversification
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• Diversification is not putting all your eggs in one basket.
• Diversification relies on the lack of a tight positive relationship among the assets'
returns, and works even when correlations are near zero or somewhat positive.
• The debate over active vs passive management is one that takes on the limits to
diversification.
Impact of Diversification on Risk and Return: Unsystematic Risk
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An empirical example relating diversification to
risk reduction
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Introduction to Risk and Return > Diversification
• Diversification is a technique for reducing risk that relies on the lack of a tight
positive relationship among the returns of various types of assets.
• The role of diversification is to narrow the range of possible outcomes.
• Unsystematic risk does not factor into an investment's risk premium, since this
type of risk can be diversified away.
Impact of Diversification on Risk and Return: Systematic Risk
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The Security Market Line
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Introduction to Risk and Return > Diversification
• Expected Risk and Risk Premium
• Defining the Security Market Line
• Impact of the SML on the Cost of Capital
Understanding the Security Market Line
Introduction to Risk and Return > Understanding the Security Market Line
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• In return for undertaking risk, investors expect to be compensated in such as a
way as to reasonably reward them.
• Systemic risk is the risk associated with an entire financial system or entire
market. It cannot be diversified away.
• Unsystematic risk is risk to which only specific classes of securities or industries
are vulnerable, and with proper grouping of assets it can be reduced or even
eliminated.
• Beta is a number describing the correlated volatility of an asset in relation to the
volatility of the benchmark that said asset is being compared to -- usually the
market as expressed in an index.
• The term risk premium refers to the amount by which an asset's expected rate of
return exceeds the risk-free interest rate.
Expected Risk and Risk Premium
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Beta
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Introduction to Risk and Return > Understanding the Security Market Line
• The security market line is the theoretical line on which all capital investments lie.
Investors want higher expected returns for more risk.
• On a graph, the line has risk on its horizontal axis (independent variable) and
expected return on the vertical axis (dependent variable).
• Assuming a linear relationship between risk and return, the assumption is that the
y-intercept is the return on a risk-free investment (the risk free rate), and the slope
is the premium on risk in terms of expected returns.
• Given two investments with the same expected return, investors would always
choose less risk. Someone with opposite preferences might better be called a
gambler.
Defining the Security Market Line
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The equation that defines the security market
line.
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Introduction to Risk and Return > Understanding the Security Market Line
• The security market line is a hypothetical concept that suggests that investors
require compensation in the form of expected returns for the risk the investment
exposes them to.
• A capital investment below the security market wouldn't be efficiently priced to the
buyer of the investment. A higher return or lower price would be required, both
increasing the cost of capital.
• A capital investment above the security market line wouldn't be efficiently priced
for the seller or whomever raises the capital. A lower return or higher price would
be necessary to justify this cost of capital for the company.
Impact of the SML on the Cost of Capital
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The Security Market Line
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Introduction to Risk and Return > Understanding the Security Market Line
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Appendix
Key terms
• beta In finance, the Beta (β) of a stock or portfolio is a number describing the correlated volatility of an asset in relation to the
volatility of the benchmark that said asset is being compared to.
• beta Average sensitivity of a security's price to overall securities market prices.
• capital asset pricing model In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate
required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-
diversifiable risk.
• Co-Variance In probability theory and statistics, co-variance is a measure of how much two random variables change together.
• Correlation Matrix A matrix that shows a set of correlations between two random variables over a number of observations.
• diversifiable risk the potential for loss which can be removed by investing in a variety of assets
• expected return The expected return of a potential investment can be computed by computing the product of the probability of a
given event and the return in that case and adding together the products in each discrete scenario.
• expected value The expected value of a random variable is the weighted average of all possible values that this random
variable can take on.
• inflation An increase in the general level of prices or in the cost of living.
• line of credit source of debt extended to a government, business or individual by a bank or other financial institution
• market risk the potential for loss due to movements in prices in a system of exchange
• market risk premium the amount by which expected rate of return of the exchange system exceeds the risk-free interest rate
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Introduction to Risk and Return
• mergers and acquisitions Mergers and acquisitions (M&A) is an aspect of corporate strategy, corporate finance, and
management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help
an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other
child entity, or using a joint venture.
• Normalized variable In statistics, a normalized variable is one that is calculated using a ratio of itself and some benchmark
figure. Normalized figures tend to be smaller than the original values.
• portfolio The group of investments and other assets held by an investor.
• risk The potential (conventionally negative) impact of an event, determined by combining the likelihood of the event occurring
with the impact, should it occur.
• Risk free rate Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
• security market line Security market line (SML) is the representation of the capital asset pricing model. It displays the expected
rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).
• standard deviation The standard deviation of an investment is obtained by taking the square root of the variance. It has a more
straightforward meaning than variance. It tells you that in a given year, you can expect an investment's return to be one
standard deviation above or below the average rate of return.
• Strategic Asset Allocation The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal
balance between expected risk and return for a long-term investment horizon.
• systematic risk The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as
its beta.
• systematic risk systematic or non-diversifiable risk is a term given to the portion of risk in a portfolio that cannot be diversified
away by holding a pool of individual assets and therefore commands a return in excess of the risk-free-rate.
• systemic risk Refers to the risk common to all securities which cannot be diversified away.
• treasury bill Treasury bills (or T-Bills) mature in one year or less. They do not pay interest prior to maturity; instead they are sold
at a discount of the par value to create a positive yield to maturity.
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Introduction to Risk and Return
• Unsystematic risk Unsystematic or diversifiable risk is a term given to the portion of risk in a portfolio that can be diversified
away by holding a pool of individual assets.
• Variable Rate Mortgage A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan
with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on
the credit markets.
• variance In finance, variance is a term used to measure the degree of risk in an investment. It is calculated by finding the
average of the squared deviations from the mean rate of return.
• weighted average In statistics, a weighted average is an average that takes each object and calculates the product of its weight
and its figure and sums all of these products to produce one average. It is implied that all the individual weights add to 1.
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Introduction to Risk and Return
Volatility begets volatility
Data shown is from the period of Jan. 1990-Sep. 2009. Volatility is measured as the standard deviation of S&P 500 one-day returns over a month's
period.
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Introduction to Risk and Return
An empirical example relating diversification to risk reduction
In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3,290
securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal
amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains
from diversification come for n≤30.
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Introduction to Risk and Return
The Security Market Line
This is an example of a security market line graphed. The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and
the slope is the premium that the market charges for risk.
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Introduction to Risk and Return
The Security Market Line
The location of a financial instrument above, below, or on the security market line will lead to consequences for a company's cost of capital.
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Introduction to Risk and Return
Average Returns for Different Weighting Schemes
Different returns are expected for different asset allocations given historical averages
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Introduction to Risk and Return
The equation that defines the security market line.
Look at the equation and remember that old formula of a line: y = mx + b. In this case it looks rearranged, like y = b + mx, but the real question is what do
the slope and y-intercept actually represent?
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Introduction to Risk and Return
How much do investors want to pay to have to take the good with the bad?
Calculating variance is a 3 step process once expected return has been calculated. Calculate deviations from mean (blue), square the deviations
(yellow), multiply the squared deviation by its original probability (orange). Get brownie points by taking the square root of that number and interpret its
meaning in the form of a sentence.
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Introduction to Risk and Return
Variance of any portfolio
The formula shows that the overall variance in a portfolio is the sum of each individual variance along with the cross-asset correlations.
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Introduction to Risk and Return
Care to roll the dice?
Is a bet that doesn't always pay out, but pays out big when it does a good bet? Is playing the lottery a good bet? Would it be a good bet if tickets were
only $0.10 instead of $1.00?
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Introduction to Risk and Return
The Security Market Line
Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.
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Introduction to Risk and Return
World countries Standard & Poor's ratings
An example of the credit ratings prescribed by Standard & Poor's as a result of their respective long-term liability analysis for debt issued at the national
government level. Countries issue debt to build national infrastructure. Look how expensive it is to raise capital for such projects based on geographic
region.
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Introduction to Risk and Return
Inflation
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
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Introduction to Risk and Return
Illustration of Modern Portfolio Theory
Diversifying asset classes can reduce portfolio variance without diminishing expected return
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Introduction to Risk and Return
A Fruitful Portfolio
How would you calculate the expected return on this portfolio?
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Introduction to Risk and Return
Calculating Beta
Two hypothetical portfolios; what do you think each Beta value is?
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Introduction to Risk and Return
Diversified Portfolio
Asset classes and their weightings for a particular portfolio
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Introduction to Risk and Return
Beta
Beta is a measure that relates the rate of return of an asset, ra, with the rate of return of a benchmark, rb.
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Introduction to Risk and Return
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Introduction to Risk and Return
An investment portfolio has a 30% chance of earning $125,000 in
a year, a 40% chance of earning $50,000, a 15% chance of
earning nothing and 15% chance of losing $20,000. What is its
expected return?
A) $62,000
B) $54,500
C) $38,750
D) $50,000
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Introduction to Risk and Return
An investment portfolio has a 30% chance of earning $125,000 in
a year, a 40% chance of earning $50,000, a 15% chance of
earning nothing and 15% chance of losing $20,000. What is its
expected return?
A) $62,000
B) $54,500
C) $38,750
D) $50,000
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Introduction to Risk and Return
You have $20,000. You plan on purchasing a house in one year,
but you will need to have $22,500 for the downpayment. Which of
the following is a good investment opportunity to ensure you have
the money necessary to make your downpayment in a year?
A) A portfolio with an expected return of $24,000 and a standard
deviation of 10%.
B) A portfolio with an expected return of $30,000 and a standard
deviation of 15%.
C) A portfolio with an expected return of $27,000 and a standard
deviation of 20%.
D) All of these options would be a good investment.
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Introduction to Risk and Return
You have $20,000. You plan on purchasing a house in one year,
but you will need to have $22,500 for the downpayment. Which of
the following is a good investment opportunity to ensure you have
the money necessary to make your downpayment in a year?
A) A portfolio with an expected return of $24,000 and a standard
deviation of 10%.
B) A portfolio with an expected return of $30,000 and a standard
deviation of 15%.
C) A portfolio with an expected return of $27,000 and a standard
deviation of 20%.
D) All of these options would be a good investment.
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Introduction to Risk and Return
What factors should be considered when weighting an investment
portfolio?
A) The time frame of the investment.
B) The investor's risk tolerance.
C) All of these answers.
D) The specific risks of the individual securities.
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Introduction to Risk and Return
What factors should be considered when weighting an investment
portfolio?
A) The time frame of the investment.
B) The investor's risk tolerance.
C) All of these answers.
D) The specific risks of the individual securities.
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Introduction to Risk and Return
A portfolio has $70,000 of bonds and $30,000 of stock. The bonds
are 80% likely to have a 10% return and 20% likely to have a 0%
return. The stock is 50% likely to have a 20% return and 50%
likely to have a 10% loss. What is the expected return?
A) 5.9%
B) 2.9%
C) 13%
D) 7.1%
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Introduction to Risk and Return
A portfolio has $70,000 of bonds and $30,000 of stock. The bonds
are 80% likely to have a 10% return and 20% likely to have a 0%
return. The stock is 50% likely to have a 20% return and 50%
likely to have a 10% loss. What is the expected return?
A) 5.9%
B) 2.9%
C) 13%
D) 7.1%
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Introduction to Risk and Return
The adequately diversify your portfolio, you need to do more than
just own a variety of securities. Which of the following is a
necessary component of a well-diversified portfolio that has a low
variance?
A) The component securities have small or negative correlation
coefficients.
B) The portfolio's components are in a variety of asset classes, such as
commodities and derivatives.
C) The portfolio is reviewed and rebalanced based on updated
projections and new information.
D) All of these answers.
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Introduction to Risk and Return
The adequately diversify your portfolio, you need to do more than
just own a variety of securities. Which of the following is a
necessary component of a well-diversified portfolio that has a low
variance?
A) The component securities have small or negative correlation
coefficients.
B) The portfolio's components are in a variety of asset classes, such as
commodities and derivatives.
C) The portfolio is reviewed and rebalanced based on updated
projections and new information.
D) All of these answers.
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Introduction to Risk and Return
A potential merger is announced between Company A and B.
Which of the following is a potential response to that
announcement?
A) Company A's stock is downgraded, because analysts believe the
merger signals A is financially weak.
B) All of these answers.
C) Company A's stock is upgraded because analysts believe the merger
will increase its marketshare.
D) Nothing happens because analysts picked up on signals prior to the
announcement that the merger would occur.
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Introduction to Risk and Return
A potential merger is announced between Company A and B.
Which of the following is a potential response to that
announcement?
A) Company A's stock is downgraded, because analysts believe the
merger signals A is financially weak.
B) All of these answers.
C) Company A's stock is upgraded because analysts believe the merger
will increase its marketshare.
D) Nothing happens because analysts picked up on signals prior to the
announcement that the merger would occur.
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Introduction to Risk and Return
In which of the following ways can technical analysts use a
company's announcements, news and returns to determine
whether to buy the company's stock?
A) They can review the company's press releases to analyze its
competitive advantages.
B) They can use the returns to study the company's growth patterns and
stock price fluctuations.
C) They can review the company's press releases to evaluate the
company's managerial competence.
D) All of these answers.
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Introduction to Risk and Return
In which of the following ways can technical analysts use a
company's announcements, news and returns to determine
whether to buy the company's stock?
A) They can review the company's press releases to analyze its
competitive advantages.
B) They can use the returns to study the company's growth patterns and
stock price fluctuations.
C) They can review the company's press releases to evaluate the
company's managerial competence.
D) All of these answers.
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Introduction to Risk and Return
A company issues a bond with the provision that it may pay off the
debt early. This bond is subject to which type of risk?
A) Prepayment risk.
B) Model risk.
C) Interest rate risk.
D) All of the above.
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Introduction to Risk and Return
A company issues a bond with the provision that it may pay off the
debt early. This bond is subject to which type of risk?
A) Prepayment risk.
B) Model risk.
C) Interest rate risk.
D) All of the above.
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Introduction to Risk and Return
A relatively new tech company issues a bond that is publicly
traded. The company is based in the US and pays interest in
dollars. The potential investor lives in the UK. Which of the
following risks does the investor face if he buys the bond?
A) Market risk.
B) Foreign investment risk.
C) Credit risk.
D) All of these answers.
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Introduction to Risk and Return
A relatively new tech company issues a bond that is publicly
traded. The company is based in the US and pays interest in
dollars. The potential investor lives in the UK. Which of the
following risks does the investor face if he buys the bond?
A) Market risk.
B) Foreign investment risk.
C) Credit risk.
D) All of these answers.
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Introduction to Risk and Return
Using the Value at Risk methodology, an investment advisor says
that she is 90% sure that her investment portfolio will not lose
more than $250,000 in a given day. Based on that description,
which of the following statements is true?
A) It is 90% sure that the portfolio will not earn more than $250,000 in a
given day.
B) Investors should expect to see losses 1 out of every 10 days.
C) The portfolio will lose more than $250,000 every month.
D) All of these answers.
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Introduction to Risk and Return
Using the Value at Risk methodology, an investment advisor says
that she is 90% sure that her investment portfolio will not lose
more than $250,000 in a given day. Based on that description,
which of the following statements is true?
A) It is 90% sure that the portfolio will not earn more than $250,000 in a
given day.
B) Investors should expect to see losses 1 out of every 10 days.
C) The portfolio will lose more than $250,000 every month.
D) All of these answers.
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Introduction to Risk and Return
A portfolio has a 95% certainty that it won't lose more than
$50,000 in a given day. On the big loss days, there is a 30%
chance the portfolio will lose $50,000 and a 70% chance it will
lose $75,000. What is the portfolio's expected shortfall?
A) ES_0.05 = $57,500
B) ES_0.05 = $67,500
C) ES_0.95 = $67,500
D) ES_0.95 =$57,500
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Introduction to Risk and Return
A portfolio has a 95% certainty that it won't lose more than
$50,000 in a given day. On the big loss days, there is a 30%
chance the portfolio will lose $50,000 and a 70% chance it will
lose $75,000. What is the portfolio's expected shortfall?
A) ES_0.05 = $57,500
B) ES_0.05 = $67,500
C) ES_0.95 = $67,500
D) ES_0.95 =$57,500
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Introduction to Risk and Return
A portfolio is composed of 30% stock, 20% bonds, and 50%
mutual funds. The stock is expected to have a 10% return, the
bonds a 5% return and the mutual funds a 7% return. What is the
expected return of the portfolio?
A) 7.3%
B) 7%
C) 8.1%
D) 7.5%
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Introduction to Risk and Return
A portfolio is composed of 30% stock, 20% bonds, and 50%
mutual funds. The stock is expected to have a 10% return, the
bonds a 5% return and the mutual funds a 7% return. What is the
expected return of the portfolio?
A) 7.3%
B) 7%
C) 8.1%
D) 7.5%
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Introduction to Risk and Return
A portfolio is composed of 80% stock and 20% bonds. The
variance of stock is 170 and the variance of bonds is 140. The
covariance is 30. What is the portfolio's variance?
A) 114
B) 119
C) 101
D) 168
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Introduction to Risk and Return
A portfolio is composed of 80% stock and 20% bonds. The
variance of stock is 170 and the variance of bonds is 140. The
covariance is 30. What is the portfolio's variance?
A) 114
B) 119
C) 101
D) 168
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Introduction to Risk and Return
Over a period of three days, a company stock increased by 4%,
decreased by _______%, then increased by 6%. During that
same period, the Dow Jones increased by _______%, decreased
by 1% , and then increased by 3%. What is the company's beta?
A) -2
B) 2
C) 0.5
D) -0.5
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Introduction to Risk and Return
Over a period of three days, a company stock increased by 4%,
decreased by _______%, then increased by 6%. During that
same period, the Dow Jones increased by _______%, decreased
by 1% , and then increased by 3%. What is the company's beta?
A) -2
B) 2
C) 0.5
D) -0.5
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Introduction to Risk and Return
Under the capital asset pricing model (CAPM), what beta value is
considered risky?
A) A beta equal to 0
B) A beta above 1
C) A beta between 0 and 1
D) None of these
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Introduction to Risk and Return
Under the capital asset pricing model (CAPM), what beta value is
considered risky?
A) A beta equal to 0
B) A beta above 1
C) A beta between 0 and 1
D) None of these
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Introduction to Risk and Return
Which of the following accurately describes unsystemic risk?
A) Unsystemic risk can be diversified away.
B) All of these answers.
C) Unsystemic risk is correlated to investing in only one company or
security.
D) A company losing a lawsuit which creates a massive legal liability is an
example of unsystemic risk.
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Introduction to Risk and Return
Which of the following accurately describes unsystemic risk?
A) Unsystemic risk can be diversified away.
B) All of these answers.
C) Unsystemic risk is correlated to investing in only one company or
security.
D) A company losing a lawsuit which creates a massive legal liability is an
example of unsystemic risk.
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Introduction to Risk and Return
Which of the following statements accurately describes systemic
risk?
A) By diversifying your stock portfolio, you can minimize systemic risk.
B) Systemic risk is what provides a stock its "risk premium."
C) An example of a systemic risk is if you own stock in a company that
has liquidity problems.
D) All of these answers.
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Introduction to Risk and Return
Which of the following statements accurately describes systemic
risk?
A) By diversifying your stock portfolio, you can minimize systemic risk.
B) Systemic risk is what provides a stock its "risk premium."
C) An example of a systemic risk is if you own stock in a company that
has liquidity problems.
D) All of these answers.
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Introduction to Risk and Return
A stock has a beta of 0.75 in relation to the Dow Jones Industrial
Index. Today, the Dow Jones increased by 2%. Based on its beta,
predict what happened to the stock's price.
A) The stock's price increased by less than 2%.
B) The stock's price increased by 2%.
C) The stock's price increased by more than 2%.
D) The stock's price decreased by less than 2%.
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Introduction to Risk and Return
A stock has a beta of 0.75 in relation to the Dow Jones Industrial
Index. Today, the Dow Jones increased by 2%. Based on its beta,
predict what happened to the stock's price.
A) The stock's price increased by less than 2%.
B) The stock's price increased by 2%.
C) The stock's price increased by more than 2%.
D) The stock's price decreased by less than 2%.
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Introduction to Risk and Return
Which of the following statements regarding the Security Market
Line (SML) is true?
A) The x-intercept of the SML is equal to the risk-free interest rate.
B) The SML graphs unsystematic risk
C) The slope of the SML is equal to the market risk premium and reflects
the risk-return trade off.
D) All of these answers.
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Introduction to Risk and Return
Which of the following statements regarding the Security Market
Line (SML) is true?
A) The x-intercept of the SML is equal to the risk-free interest rate.
B) The SML graphs unsystematic risk
C) The slope of the SML is equal to the market risk premium and reflects
the risk-return trade off.
D) All of these answers.
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Introduction to Risk and Return
A company's security is priced above the security market line.
Which of the following statements regarding that security is true?
A) This isn't an attractive market situation for a potential investor looking
to purchase the security.
B) This is not an attractive market situation for the company issuing the
security.
C) The security is fairly priced for the amount of expected return.
D) All of these answers.
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Introduction to Risk and Return
A company's security is priced above the security market line.
Which of the following statements regarding that security is true?
A) This isn't an attractive market situation for a potential investor looking
to purchase the security.
B) This is not an attractive market situation for the company issuing the
security.
C) The security is fairly priced for the amount of expected return.
D) All of these answers.
Attribution
• Wikipedia. "Fundamental analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Fundamental_analysis
• Wikipedia. "Technical analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Technical_analysis
• Wiktionary. "beta." CC BY-SA 3.0 http://en.wiktionary.org/wiki/beta
• Wikipedia. "Fundamental analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Fundamental_analysis
• Wikipedia. "Technical analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Technical_analysis
• Wikipedia. "Public company." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Public_company
• Wikipedia. "mergers and acquisitions." CC BY-SA 3.0 http://en.wikipedia.org/wiki/mergers%20and%20acquisitions
• Wikibooks. "Real Estate Financing and Investing/Understanding Return and Risk." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Real_Estate_Financing_and_Investing/Understanding_Return_and_Risk#Risk_and_the_Risk-
Return_Trade_Off
• Wikipedia. "Beta (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Beta_(finance)
• Wikipedia. "Interest." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Interest
• Wikipedia. "Risk aversion." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_aversion
• Wiktionary. "inflation." CC BY-SA 3.0 http://en.wiktionary.org/wiki/inflation
• Wiktionary. "systematic risk." CC BY-SA 3.0 http://en.wiktionary.org/wiki/systematic+risk
• Wikipedia. "Risk-return spectrum." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk-return_spectrum
• Wikipedia. "Security market line." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Security_market_line
• Wiktionary. "line of credit." CC BY-SA 3.0 http://en.wiktionary.org/wiki/line+of+credit
• Wikipedia. "Risk premium." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_premium
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Introduction to Risk and Return
• Wikipedia. "Diversification (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Diversification_(finance)
• Wikipedia. "Market risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Market_risk
• Wiktionary. "beta." CC BY-SA 3.0 http://en.wiktionary.org/wiki/beta
• Wiktionary. "security market line." CC BY-SA 3.0 http://en.wiktionary.org/wiki/security+market+line
• Wikipedia. "Diversification (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Diversification_(finance)
• Wikipedia. "Unsystematic risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Unsystematic%20risk
• Wikipedia. "Expected return." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Expected_return
• Wikipedia. "Expected value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Expected_value
• Wikipedia. "Expected value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Expected_value
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Introduction to Risk and Return
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