Chapter 2 - Risk and Return

If the correlation were - the portfolio's standard deviation would be the weighted average of the stock's standard deviations.

+1

If two stocks have a correlation of - when one stock has a higher than expected return, then the other stock has a lower than expected return, and vice versa.

-1

For correlation between - and -, the portfolio's standard deviation is less than the weighted average of the stocks' standard deviations.

-1 & +1

A portfolio with a beta equal to - will have the same standard deviation as the market.

1

A portfolio with a beta greater than - will have a bigger standard deviation than the market portfolio.

1

A portfolio with a beta less than - will have a smaller standard deviation than the market.

1

The average of all stocks' beta is equal to -.

1

A well-diversified portfolio will have more than - stocks.

4

Capital Asset Pricing Model (CAPM)

A model that relates the required rate of return on a security to its systematic risk as measured by beta

Market Portfolio

A portfolio consisting of all stocks

The - defines the relevant risk of an individual stock as the amount of risk that the stock contributes to the market portfolio.

CAPM

If you write a - -, you receive cash in return for an obligation to sell a share at the strike price.

Call option

- can eliminate all risk.

Diversification

If all the stocks' weights in a portfolio are -, then a stock with a beta that is twice as big as another stock's beta contributes twice as much risk.

Equal

The risk of a portfolio consisting of stocks tends to decline and to approach some limit as the number of stocks in the portfolio -.

Increases

Beta and required rate of return have an - relationship.

Inverse

Probability Distribution

List of possible outcomes with associated probabilities

When investors are less concerned about risk, the market premium is -.

Low

A well-diversified portfolio only has - risk.

Market

The size of the - - premium depends on the degree of risk aversion that investors have on average.

Market risk

The yield on long-term treasury bonds is often used to measure the - - rate.

Risk-free

To induce an investor to take on a risky investment, the investor will need a return that is at least as big as the - - rate.

Risk-free

Selling a - stock means that you borrow a share from a broker and sell it.

Short

With a - position in a futures contract on the market index, you are obligated to sell a share at a fixed price.

Short

Security Market Line (SML)

Shows the stock's risk premium is equal to the product of the stock's beta and the market risk premium

An asset's risk can be analyzed in two ways: on a - - basis, where the asset is considered in isolation; and on a - basis, where the asset is held as one of a number of assets in a portfolio.

Stand alone basis & portfolio basis

The historical - - is often used as an estimate of future variability.

Standard Deviation

A large - - means that possible outcomes are widely dispersed, whereas a small - - means that outcomes are more tightly clustered around the expected value.

Standard deviation

If a portfolio's - - is less than the weighted average of the individual stocks' - -, then diversification provides a benefit.

Standard deviation & standard deviation

The rate of return calculation - the dollar return by considering the annual return per unit of investment.

Standardizes

Strong Form

States that current market prices reflect all pertinent information, whether publicly available or privately held.

Semistrong Form

States that current market prices reflect all publicly available information.

The slope of the SML reflects the extend to which investors are averse to risk: the - the sloper of the line, the greater the average investor's aversion to risk.

Steeper

Diversifiable Risk

That part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company-specific, or unsystematic, risk

Market Risk Premium

The extra rate of return that investors require to invest in the stock market rather than purchase risk-free securities

Stand-Alone Risk

The risk an investor would face if she held only this one asset

Relevant Risk

The stock's contribution to a well-diversified portfolios risk

The weight of an asset in a portfolio is the percentage of the portfolio's - - that is invested in the asset.

Total value

There are three forms of the efficient markets hypothesis:

Weak form, semi strong form, and strong form.

With a normal distribution, the actual return will be within - standard deviation of the expected return - of the time.

plus/minus 1 & 68.26%

Weak Form

Asserts that all information contained in past price movements is fully reflected in current market prices.

Efficient Markets Hypothesis (EMH)

Asserts that stocks are always in equilibrium and it is impossible for an investor to "beat the market" and consistently earn a higher rate of return than is justified by the stock's risk.

- cannot be observed, only estimated.

Beta

- measures how much risk a stock contributes to a well-diversified portfolio.

Beta

A stock with a high standard deviation will tend to have a high -.

Beta

The higher the stock's -, the higher its required rate of return.

Beta

The relevant measure of risk is called - .

Beta

The CAPM is an ex ante model, which means that all of the variables represent before-the-fact, - values.

Expected

The beta coefficient used by investors should reflect the relationship between a stock's - return and the market's expected return during some future period.

Expected

Because past variability is often repeated, past variability may be a reasonably good estimate of - -.

Future risk

Most financial assets are actually held as parts of -.

Portfolios

A - option gives you the option to sell a share at a fixed strike price.

Put

The concept of - provides investors with a convenient way to express the financial performance of an investment.

Return

The required - depends on the risk-free rate, the market risk premium, and the stock's beta.

Return

Realized Rates of Return

Returns that were actually earned during some past period. Actual returns usually turn out to be different from expected returns except for riskless assets

As risk aversion increases, so does the - premium.

Risk

The CAPM shows that the - - for an individual stock is equal to the product of the stock's beta and the market risk premium.

Risk premium

Market Risk

Risk that affects all companies in the stock market

Expected Return on a Portfolio

the weighted average of the expected returns on the individual assets in the portfolio.

Required Return on a Portfolio

the weighted average of the required returns on the individual assets in the portfolio.