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Chapter 11&12- Investments
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Terms in this set (70)
Portfolios with many investments usually produce
A more consistent and stable total return
We assume that investors prefer ______ return
More
We assume that investors prefer ______ risk
Less
Expected return
Average return on a risky asset expected in the future
The expected return on a security or other asset is equal to
The sum of the possible returns multiplied by their probabilities
Portfolio
Group of assets such as stocks and bonds held by an investor
Portfolio weight
Percentage of a portfolios total value invested into a particular asset
Standard deviation declines as number of securities _____
Increased
An important foundation of the diversification effect is the:
Random selection of stocks
Modern portfolio theory
Examines past returns and volatility of various asset classes and also looks at their correlation
Modern portfolio theory assumes that diversification:
Always reduces risk
The diversification benefit does depend on the _______ over which returns and variances are calculated
time period
Diversification
Spreading an investment across assets
Principle of diversification
Spreading an investment across assets will eliminate some, but not all, of the risk
Risk that can be eliminated by diversification
Diversifiable risk
Some of the riskiness associated with individual assets can be eliminated by:
Forming portfolios
Nondiversifiable risk
A minimum level of risk that cannot be eliminated by diversifying
Volatility ______ over time
Increases
Correlation of +1
Two assets have a perfect positive correlation
Zero correlation
Two assets are uncorrelated
Perfect negative correlation
Indicated that they always move in opposite directions
Diversification works because
Asset returns are generally not perfectly correlated
If two assets have perfect negative correlation, then it is possible to
Combine them such that all risk is eliminated
Asset allocation
How an investor spreads portfolio dollars among assets
Efficient portfolio
A portfolio that offers the highest return for its level of risk
The lower the correlation
The greater the gain from diversification
Markowitz efficient frontier
The set of portfolios with the maximum return for a given standard deviation
- The upper left hand boundary
Inefficient portfolio
One that offers too little return for its risk
The average annual standard deviation of a return for a single, randomly chosen stock is
50%
The average annual standard deviation for an equally-weighted portfolio of many stocks is about
20%
If the return on two stocks are highly correlated, the have a strong tendency to:
Move up and down together
If they have no correlation then
There is no connection between the two
If they are negatively correlated, they tend to
Move in opposite directions
If two stocks have the same expected return of 12%, then any portfolio of the two stocks will also have an expected return of 12%. T/F
True
If two stocks have the same standard deviation of 45%, then any portfolio of the two stocks will also have a standard deviation of 45%. T/F
False
Why should younger investors be willing to hold a larger amount of equity in their portfolios?
Younger investors have a greater ability to modify their workflow, time, etc to offset the loss
Assume you are a very risk-averse investor. Why might you still be willing to add an investment with high volatility to your portfolio?
An investment with high volatility could actually reduce the risk of the overall portfolio it its correlation to the existing assets is very low
Suppose two assets have zero correlation and the same standard deviation. What is true about the minimum variance portfolio?
It determines the lower bond of the efficient frontier
Expected returns
The normal, or expected, return from stock that investors predict or expect
Unexpected returns
Uncertain, risky part
- Comes from unexpected information revealed during the year
Unexpected return=
Total return- expected return
On average, the actual return equals
The expected return
Systematic risk
- Influences a large number of assets
- Nondiversifiable
Nonsystematic risk
- Risk that influences a single asset or a small group of assets
- Diversifiable
Examples of systematic risk
- Inflation
- Interest rates
- GDP
Unsystematic risk is essentially
Eliminated by diversification
A portfolio with many assets has almost no
Unsystematic risk
For a well diversified portfolio, ______ risk is negligible
Unsystematic
Essentially all risk is
Systematic
Systematic risk principle
The reward for bearing risk depends only on the systematic risk of an investment
The expected return on an asset depends only on its
Systematic risk
There is no reward for bearing unsystematic risk because:
It can be eliminated by diversification
- The market does not reward risks that are borne unnecessary
Beta coefficient
Measure of the relative systematic risk of an asset
Assets with betas larger than 1 have
More systematic risk
A risk free asset has a beta of
Zero
The reward to risk ratio must be:
The same for all assets in a competitive financial market
Security market line
Graphical representation of the linear relationship between systematic risk and expected return
Market risk premium
The risk premium on a market portfolio
Risk premium
Reward for bearing risk
Why is some risk diversifiable? Why are some risks nondiversifiable?
By investing in a variety of assets, this unique portion of the total risk can be almost completely eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk cannot be costlessly eliminated.
Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?
Systematic risk can be controlled, but only by a costly reduction in expected returns
Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2 percent in the coming year, compared to the 5 percent for the year just completed. Will security prices increase, decrease or stay the same following this announcement?
- There would be no change in security prices if this expectation had been fully anticipated and prices
- If the market had been expecting something other than 2% and the expectation was incorporated into security prices, then it would cause a general change
- Prices would drop if the anticipated growth rate had been more than 2 percent, and prices would rise if the growth rate had been less than 2 percent
The most important characteristic in determining the expected return of a well-diversified portfolio is the variances of the individual assets in the portfolio. T/F
False- Expected returns depend on systematic risk, not total risk
If the market values stocks based on expectations of the future, why are numbers summarizing past performance relevant?
Earnings contain information about recent sales and costs. This information is useful for projecting future growth sales and cash flows.
Is it possible that a risky asset can have a beta of 0?
Yes. Such an assets return is simply uncorrelated with the overall market. Based on the CAPM, this assets expected return would be equal to the risk free rate
Is it possible that a risky asset could have a negative beta?
Yes. The return would be less than the risk free rate
A portfolio with a zero beta can always be created by
Combining long and short positions
A negative beta can be created by:
Shorting an asset with a positive beta
Explain what it means for all assets to have the same reward-to risk ratio
The implication is that every asset provides the same risk premium for each unit of risk. The only way to increase your return is to accept more risk. Investors will only take more risk if the reward is higher, and a constant reward- to ratio ensures this will happen
Why would we expect that all assets have the same reward-to risk ratio in liquid, well functioning markets?
Due to the competition and investor risk aversion. If an asset has a reward-to-risk ratio that is lower than all other assets, investors will avoid that asset, thereby driving the price down increasing the expected return and the ratio.
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