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16 Cards in this Set
- Front
- Back
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What does “investment risk” mean? |
Investment risk is related to the probability of actually earning a low ornegative return: The greater the chance of a low or negative return, the riskier theinvestment. |
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How does one calculate the standard deviation? |
1. Calculate the expected rate of return: 2. Subtract the expected rate of return (rˆ) from each possible outcome (ri) to obtain a set of deviations about rˆ. 3. Square each deviation, then multiply the result by the probability of occurrence for its related outcome, and then sum these products to obtain the variance of the probability distribution. 4. Finally, square root the variance to obtain the standard deviation. |
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Which is a better measure of risk if assets have different expected returns: (1) the standard deviationor (2) the coefficient of variation? Why? |
The coefficient of variation is the standard deviation divided by the expected return. The coefficient of variation shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same. |
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Explain the following statement: “Most investors are risk averse.” |
If you choose the less risky investment, you are risk averse. Mostinvestors are indeed risk averse, and certainly the average investor is risk averse withregard to his or her “serious money.” |
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How does risk aversion affect rates of return? |
In a market dominatedby risk-averse investors, riskier securities must have higher expected returns, as estimatedby the marginal investor, than less risky securities. If this situation does not exist, buyingand selling in the market will force it to occur. |
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An investment has a 30% chance of producing a 25% return, a 40% chance of producing a 10% return,and a 30% chance of producing a -15% return. What is its expected return? What is its standarddeviation? |
Expected Return = 7% 18, 3, -22 97.2, 3.6, 145.2 15.7 |
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A stock’s returns for the past 3 years are 10%, -15%, and 35%. What is the historical average return? What is the historical sample standard deviation? |
10% |
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Explain the following statement: “An asset held as part of a portfolio is generally less risky than the sameasset held in isolation.” |
The portfolio’s risk willalmost always be smaller than the weighted average of the assets’. In fact, it is theoretically possible to combine stocks that are individually quite risky as measured bytheir standard deviations to form a portfolio that is completely risk-less. |
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Why is beta the theoretically correct measure of a stock’s risk? |
Since a stock’s beta coefficient determines how the stock affects the risk of a diversified portfolio, beta is the most relevant measure of any stock’s risk. |
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If you plotted the returns on a particular stock versus those on the Dow Jones Index over the past 5 years,what would the slope of the regression line you obtained indicate about the stock’s market risk? |
How correlated the stock is to the Dow Jones Index |
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An investor has a three-stock portfolio with $25,000 invested in Dell, $50,000 invested in Ford, and$25,000 invested in Wal-Mart. Dell’s beta is estimated to be 1.20, Ford’s beta is estimated to be 0.80,and Wal-Mart’s beta is estimated to be 1.0. What is the estimated beta of the investor’s portfolio? |
.25(1.2) + .50(.8) + .25 (1) = .95 |
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What does the R2 measure? What is the R2 for a typical company? |
The R2 value shown in the chart measures the degree of dispersionabout the regression line. Statistically speaking, it measures the percentage of thevariance that is explained by the regression equation. An R2 of 1.0 indicates thatall points lie exactly on the line, hence that all of the variance of the y-variable isexplained by the x-variable. |
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A stock’s beta coefficient, b,... |
... is a measure of its market risk. Beta measures the extent to which the stock’s returns move relative to the market. |
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A high-beta stock is... |
...more volatile than an average stock, while a low-beta stock is less volatile than an average stock. An average stock has b 1.0. |
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The beta of a portfolio is... |
... a weighted average of the betas of the individual securities in the portfolio. |
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The Security Market Line (SML) equation shows... |
the relationship between a security’s market risk and its required rate of return. The return required forany security i is equal to the risk-free rate plus the market risk premiumtimes the security’s beta: ri = rRF (RPM)bi. |
