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FIN325: Chapter 11 Risk and Return
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Terms in this set (80)
expected returns are based on...
the probabilities of possible outcomes
expected returns equation
E(R) = w1R1 + w2Rq + ...+ wnRn
variance and standard deviation measure
the volatility of returns
variance =
the weighed average of squared deviations
standard deviation =
square root of variance
portfolio
collection of assets
an asset's ____ and _____ impact how the stock affects the risk and return of the portfolio
risk, return
what measures the risk-return trade-off for a portfolio
portfolio expected return and deviation (just as with individual assets)
expected return of a portfolio
the weighed average of the expected returns for each asset in the portfolio
weights (wj) =
% of portfolio invested in each asset
portfolio standard deviation is NOT...
a weighted average of the standard deviation of the component securities' risk
(if it were, there would be no benefit to diversification)
announcements and news contain both
expected and surprise comments
the ______ component of announcements affects stock prices
surprise
efficient markets result from
investors trading on unexpected news
the easier it is to trade on surprises, the more _____ markets should be
efficient
total return =
expected return + unexpected return
R = E(R) + U
same as
expected return E(R) + systematic portion (M) + unsystematic portion (e)
E(R) + m + ε
unexpected return (U) =
systematic portion (m) + unsystematic portion (ε)
systematic risk
factors that affect a large number of assets
also called "non-diversifiable risk" and "market risk"
examples of systematic risk
changes in GDP, inflation, interest rates, etc.
unsystematic risk
risk factors that affect a limited number of risks
also called "diversifiabled risk," "unique risk," and/or "asset-specific risk"
type of risk that can be eliminated by combining assets into portfolios
unsystematic risk
examples of unsystematic risk
labor strikes, part shortages, etc.
______ can substantially reduce risk without an equivalent reduction in expected returns
diversification
-reduces the variability of returns
-caused by the offset of worse-than-expected returns from one asset by better-than-expected returns from another
minimum level of risk that cannot be diversified away
systematic portion
as more stocks are added, each new stock has a ______ risk-reducing impact on the portfolio
smaller
standard deviation of the portfolio falls very slowly after about ___ stocks are included
40
-the lower limit for standard deviation of a portfolio ≈ 20% - standard deviation of systematic portion
forming well-diversified portfolios can eliminate about ___ the risk of owning a single stock
half
stand-alone risk =
total risk
total risk =
systematic risk + unsystematic risk
the standard deviation of returns is a measure of
total risk
for well-diversified portfolios, _____ risk is very small
unsystematic
total risk for a diversified portfolio is essentially equivalent to the _____ risk
systematic
systematic risk principle
-there is a reward for bearing risk
-there is no reward for bearing risk unnecessarily
the expected return (market required return) on an asset depends only on
that asset's systematic or market risk
market risk for individual securities
the contribution of a security to the overall riskiness of a portfolio
market risk for individual stocks is relevant for...
stocks held in well-diversified portfolios
market risk for individual securities is measured by...
a stock's beta coefficient
market risk for individual securities measures...
the stock's volatility relative to the market
if beta = 1.0
stock has average risk
if beta > 1.0
stock is riskier than average
if beta < 1.0
stock is less risky than average
most stocks have betas in the range of...
.5 to 1.5
beta of the market =
1.0
beta of a t-bill =
0
portfolio beta =
weighted average of the betas of the assets in the portfolio
risk premium =
E(R) - risk free
the higher the beta, the _____ the risk premium should be
greater
the relationship between the risk premium and beta can be defined so that we can estimate....
the expected return
reward-to-risk ratio:
expected return of asset - Risk free/ Beta of asset
reward-to-risk ratio equals...
slope of line on graph
in (market) equilibrium, all assets and portfolios must have the same...
reward-to-risk ratio
in market equilibrium, each ratio must equal...
the reward-to-risk ratio for the market
security market line
the representation of the market equilibrium
the slope of the SML =
reward to risk ratio
slope of SML line equation
E(Rm) - risk free (=market risk premium)
-since beta of market is always 1
the security market line is part of the...
capital asset pricing model (CAPM)
E(R(vJ))=risk free + (E(Rm) - risk free)beta
the capital asset pricing model (CAPM) defines the relationship between...
risk and return
CAPM equation
expected return on security = risk-free rate + beta (return on market - risk-free)
if an asset's systematic risk (Beta) is known, ____ can be used to determine its expected return
CAPM
risk free measures...
the pure time value of money
RPM = (E(RM)-Rf) measures...
the reward for bearing systematic risk
beta measures
the amount of systematic risk
what does variance measure
-the spread of the sample of returns
-the riskiness of a security's returns
4 steps for the computation of variance
1. calculate expected return
2. calculate the deviation of each return from the expected return
3. square each deviation
4. calculate the average squared deviation
_____ risk is the only risk important to the well diversified investor
systematic
the minimum required return on a new project
cost of capital
variance is a measure...
of the squared deviations of a security's return from its expected returns
what to use to determine the appropriate required return for an investment
security market line
if investors are averse, it is reasonable to assume that the risk premium for the stock market will be
positive
what are the two components of risky return in the total return equation?
unsystematic risk and market risk
what two factors determine a stock's total return?
expected return and unexpected return
what will happen to systematic risk when securities are added to a portfolio?
nothing
what is the slope of the SML?
the market-risk premium
when an investor is diversified only _____ risk returns
systematic
how are the unsystematic risks of two different companies in two different industries related?
there is no relationship
if an asset has a reward-to-risk ratio of 6%, that means it has a ______ of 6% per unit of _____
risk premium; systematic risk
standard deviation measures _____ risk while beta measures _____ risk
total; systematic
systematic risk is measured by
beta
portfolio diversification eliminates...
unsystematic risk
measures the amount of systematic risk present in a particular risky asset relative to that in an average risky asset?
beta coefficient
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