FIL 240 CH6 Review Questions

What is a beta? How is it used to calculate r, the investor's required rate of return?

Beta indicates the responsiveness of a security's return to changes in the market return. According to the CAPM, beta is multiplied by the market risk premium and added to the risk-free rate of return to calculate a required rate of return.

How do we measure the beta of a portfolio?

The beta for a portfolio is equal to the weighted average of the betas of individual stocks, weighted by the percentage invested in each stock.

Over the past eight decades, we have had the opportunity to observe the rates of return and the variability of these returns for different types of securities. Summarize these observations.

Data have been compiled by Ibbotson Associates, Inc. on the actual returns for the following portfolios of securities, plus the inflation rate, from 1926-2014. 1. Common stocks of large firms 2. Common stocks for small firms 3. Corporate bonds 4. Intermediate U.S. government bonds 5. U.S. Treasury bills Investors historically have received greater returns for greater risk-taking with the exception of the U.S. government bonds. All portfolios generated returns that exceeded the inflation rate. The portfolio that, on average, has consistently generated the highest rate of return has been a portfolio made up of common stocks.

If we were to graph the returns of a stock against the returns of the S&P 500 Index, and the points did not follow a very ordered pattern, what could we say about that stock? If the stock's returns tracked the S&P 500 returns very closely, then what could we say?

If a stock has a great amount of variability about its characteristic line (the line of best fit in the graph of the stock's returns against the market's returns), then it has a high amount of unsystematic or company-unique risk. If, however, the stock's returns closely follow the market movements, then there is little unsystematic risk.

What is the security market line? What does it represent?

The security market line is a graphical representation of the risk-return trade-off that exists in the market. The line indicates the minimum acceptable rate of return for investors given the level of systematic risk of a security.

What effect will diversifying your portfolio have on your returns and your level of risk?

Through diversification, we can potentially accomplish one of two results: (1) We can decrease the variability in returns without lowering the expected rate of return of the portfolio, or (2) we can increase the expected rate of return without increasing the variability in returns. The extent of these effects is in part determined by the types of assets in the portfolio. For instance, diversification has greater effect when investing in different types of assets, such as government securities and stocks, rather than just investing in different stocks.

.a. What is meant by the investor's required rate of return? b. How do we measure the riskiness of an asset? c. How should the proposed measurement of risk be interpreted?

a. An investor's required rate of return is the minimum rate of return necessary to attract an investor to purchase or hold a security. b. Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty as to the exact outcome, the greater is the risk. Risk may be measured in terms of the standard deviation of rates of return or by the variance of rates of return, which is simply the standard deviation squared. c. A large standard deviation of the returns indicates greater riskiness associated with an investment. Future cash flows have a greater potential variation. However, whether the standard deviation is large relative to the returns has to be examined with respect to other investment opportunities. Alternatively, probability analysis is a meaningful approach to capture greater understanding of the significance of a standard deviation figure. However, we have chosen not to incorporate such an analysis into our explanation of the valuation process.

What is (a) unsystematic risk (company-unique or diversifiable risk) and (b) systematic risk (market or nondiversifiable risk)?

a. Unique risk is the variability in a firm's stock price that is associated with the specific firm and not the result of some broader influence. An employee strike is an example of a company-unique influence. b. Systematic risk is the variability in a firm's stock price that is the result of general influences within the industry or resulting from overall market or economic influences. A general change in interest rates charged by banks is an example of systematic risk.