FIN 334 Chapter 2


Terms in this set (...)

Stand-Alone Risk
The risk an investor would face if he held only this one asset.
Probability Distribution
The list of all possible outcomes with a probability of occurrence assigned to each.
Chance an outcome will occur.
Expected Rate of Return (r-hat) Formula
The sum of each possible outcome times its probability of occurrence.
Expected rate of return formula=
= p(r) + p(r) +....
Coefficient of Variation (CV) Formula
The standard deviation divided by the expected return.
Risk Premium (RP)
The additional compensation investors require for assuming the additional risk of a stock.
Expected Return of a Portfolio (rp)
The weighted average of the expected returns on the individual assets in the portfolio. (With the weights being the fraction of the total portfolio invested in each asset.)
The tendency of of two variables to move together.
Correlation Coefficient
Measures the tendency of correlation to occur.
Diversifiable Risk/Firm Specific Risk
Risk that can be diversified away by holding more stocks.
Market Risk
Risk that is non-diversifiable. (E.g.- War, inflation, recessions, high interest rates, etc.)
Capital Asset Pricing Model (CAPM)
Tool used to analyze the relationship between risk and rates of return.
Relevant Risk
An individual stock's contribution to a portfolio's risk.
Beta Coefficient
Coefficient used to show the relevant risk of a stock.
Security Market Line (SML)
Shows the relationship between a stock's market risk and its required rate of return.
Return Required (Formula)
The risk-free rate plus the market risk premium times the stock's beta.
rate of return
= (amount received - amount invested)/ amount invested
= [ (mkt rate return - expected return)^2 ] *p <---all added together
standard deviation
square root of variance
realized rate of return
sample of returns over a period of time
realized rate of return equation
(add all r)/ time
what makes a well diversified portfolio?
40+ stocks in different industries
is the average investor risk averse?
an assets risk has two components:
-diversifiable risk
-market risk
diversifiable risk
can be eliminated through diversification
market risk
cannot be avoided
how is market risk measured?
by the standard deviation of returns on a well diversified portfolio
stock with a beta greater than 1
has returns that tend to be higher than the market when the market is up but tend to be below the market when the market is down
stock with a beta less than 1
has returns that tend to be lower than the market when the market is up but tend to be below the market when the market is up
in equilibrium, the expected rate of return on a stock must ______ its required return
what can cause the required rate of return to change?
-risk free rate can change because of changes in real rates or inflation
-a stocks beta can change
-investors aversion to risk can change
expected return= required return
intrinsic value = market value
Efficient markets hypothesis
-stocks are always in equilibrium
-it is impossible for an investor who does not have inside information to consistently beat the market
-essentially, stocks are fairly valued and have a required return = expected return
anchoring bias
human tendency to anchor too closely on recent events when predicting future events
the tendency of investors to follow the crowd
anchoring bias and herding can contribute to
market bubbles
beta equation
= (standard deviation of stock returns - standard deviation of market return) *
how to calulate beta of a portfolio
= (b of stock)(weight of stock) + (b of stock)(weight of stock)...
how to calculate portfolio risk
= (b of stock)(weight of stock)(std dev) + (b of stock)(weight of stock)(std dev)...
if b>1
std dev of portfolio > std dev of market
if b=1
std dev of portfolio = std de of market
required return on stock=
risk free rate + (risk premium of stock)
risk premium of stock=
b of stock * market risk premium
market risk premium=
required market return - risk free rate or return
risk premium for individual stock=
market risk premium * b
if the risk free rate increases, what happens to sml
the y coordinate increases
if the risk free rate increases, the _______ on the market increases, which could keep the market risk premium ____
required return; stable
if risk aversion increases, what happens to sml
slope increases
the ____ of the SML reflects the extene to which investors are averse to risk
changes in the beta causes changes in
required rate of return
fama-french three-factor model
one factor for market return, size effect, book-to-market effect
The probability distribution of a less risky return is more peaked than that of a riskier return. What shape would the probability distribution be for (a) completely certain returns and (b) completely uncertain returns?
a)The probability distribution for complete certainty is a vertical line.

b)The probability distribution for total uncertainty is the X-axis from - to +.
If a company's board of directors wants management to maximize shareholder wealth, should the CEO's compensation be set as a fixed dollar amount, or should there compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock's intrinsic value? Which would be the better performance measure? Why?
The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock's performance over the long run, not the stock's price on an option exercise date. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock's market price—but the price used should be an average over time rather than on a spot date.
If investors' aversion to risk increased, would the risk premium on a high-beta stock increase more or less than that on a low-beta stock? Explain
If investors' aversion to risk increased then the risk premium on high-beta stock increase more than that on a low-beta stock. It is because the effect of the change in the risk aversion is stronger on more risky securities than in less riskier securities. Beside this, there is the positive relationship between risk aversion and the risk premium. If the risk aversion increases then the risk premium also goes up causing the slope of the security market line (SML) to become steeper. The steeper the Security market lines higher the required rate of return.
If a company's beta were to double, would its expected return double?
No, expected return would not be doubled if company's beta were to double. According to Security Market Line (SML) equation, Company's expect return is Risk free return plus market risk premium (market risk - risk free return) times Company's beta.