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Fin 303 Ch7
Terms in this set (52)
Which of the following is true of risk and expected returns?
Higher the risk, higher the expected returns on an investment.
The total holding period return on an investment
consists of a capital appreciation component and an income component
The greater the risk associated with an investment, the greater is its
To calculate an expected return, each scenario return is weighted by
the probability of its occurrence
Returns on individual stocks tend to be safer than returns on stock indexes over time
The more peaked the distribution of returns, the riskier the investment.
Analysts are constantly looking for positively correlated stocks so as to enhance their portfolio's diversification.
The risk per unit of return is measured by the
coefficient of variation
In order to measure the variance of a portfolio consisting of two or more assets we need
each asset's variance
The systematic risk of an investment is measured by
What is the expected return for a stock that has a beta of 1.5, if the risk-free rate is 6% and the market rate of return is 11%?
Expected return, E(Ri) = Rrf + βi[E(Rm) - Rrf ] = 6% + [1.5 × (11% - 6%)] = 6% + [1.5 × 5%] = 13.5%
If the expected return on an asset is greater than its required return given on the Security Market Line, the stock is
The risk-free rate of return is 2.5% and the expected return on the market is 8%. If the Beta on Ridgeway Co. stock is 0.8, then what is Ridgeway's expected return?
E(Ri) = Rrf + βi[E(Rm) - Rrf ] = 2.5% + [0.8 × (8% - 2.5%)] = 2.5% + [0.8 × 5.5%] = 6.9%.
The rate of return
is what you earn on an investment, stated in percentage terms.
When people refer to the return from an investment, they are generally referring
to the total return over some investment period, or holding period.
The total holding period return consists of two components:
(1) capital appreciation
The capital appreciation component of a return
arises from a change in the price of the asset over the investment or holding period
The total holding period return
is simply the sum of the capital appreciation and income components of return:
The key point here is that the expected value reflects
the relative likelihoods of the possible outcomes.
the sum of the n individual probabilities, the p 's, always equals 1, or 100 percent, when you calculate an expected value.
The sum of the probabilities cannot be less than 100 percent because you must account for all possible outcomes in the calculation.
The expected return on an asset reflects
the return that you can expect to receive from investing in that asset over the period that you plan to own
The normal distribution
is a symmetric frequency distribution that is completely described by its mean (average) and standard deviation.
reducing risk by investing in two or more assets whose values do not always move in the same direction at the same time
By investing in two or more assets whose values do not always move in the same direction at the same time,
an investor can reduce the risk of his or her collection of investments, or portfolio
A negative correlation
means that the returns tend to have opposite signs.
A positive correlation
means that when the return on one asset is positive, the return on the other asset also tends to be positive.
A correlation of 0
means that the returns on the assets are not correlated
The idea that unsystematic risk can be diversified away has direct implications for the relation between risk and return.
If the transaction costs associated with constructing a diversified portfolio are relatively low,
then rational, informed investors, such as the students who are taking this class, will prefer to hold diversified portfolios.
Diversified investors face only systematic risk,
whereas investors whose portfolios are not well diversified face systematic risk plus unsystematic risk.
The standard deviation is a measure of
Since systematic risk is, by definition, risk that cannot be diversified away,
the systematic risk of an individual asset is really just a measure of the relation between the returns on the individual asset and the returns on the market.
systematic risk is often referred
Capital Asset Pricing Model (CAPM)
a model that describes the relation between risk and expected return
(the CAPM) to find the expected return for this stock:
(1) the risk-free rate,
(3) either the market risk premium or the expected return on the market.
Security Market Line (SML)
a plot of the relation between expected return and systematic risk
How can an investor substantially reduce the total risk of his or her portfolio?
by increasing the number of stocks in the portfolio
Which of the following is best described as "the possibility of obtaining a return that is different from the expected return"?
The total risk of a security investment has two components,
systematic and diversifiable risk.
If an analyst plotted expected returns and risks of investments on a graph where the vertical axis was "return" and the horizontal axis was "risk," then investors would prefer investments that were __________ on the graph.
higher and to the left
Should a higher-than-expected return be considered as contributing to an investment's risk? Why or why not?
Yes, because this outcome adds to the probability that realized returns are different than expected.
Why are returns usually measured in percentages rather than in dollars?
to express returns in a standard form that is easy to interpret
Which of the following is the best definition of risk?
the possibility of obtaining a return that is different from expected
Which of the following would result from accounting for capital appreciation and income over a set investment period?
total holding period return
To calculate capital appreciation,
subtract the original price from ending price.
The y-intercept of the SML is the __________ and the slope of the SML is the
risk-free rate; market-risk premium.
What is the relationship between beta, expected return, and price for a stock?
The beta and expected return have a positive linear relationship, while expected return and price have an inverse relationship.
Why is the SML a straight line?
All stocks and all investors require a constant price to bear a unit of systematic risk.
What is the relationship between the SML and expected inflation?
An increase in expected inflation would result in a larger value for the y-intercept of the SML.
In the capital asset pricing model the unobservable variable is the
expected return on the market.
Which of the following is a role of indexes?
to represent the overall average performance of stock and bond markets
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