FIN 351 CH 13
CAPM Factors affecting expected return
1. Pure TVM: measured by risk-free rate 2. Reward for bearing systematic risk: measured by the MRP 3. Amount of systematic risk: measured by beta
Expected Return
weighted average of the returns of the individual assets in the portfolio
Variance
weighted squared deviation from expected return for each scenario
Of the options listed below, which is the best example of unsystematic risk?
A national decrease in consumer spending on entertainment
Which one of the following statements is accurate?
A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio
The use of weighted average is applicable to estimate future ____
Expected return, standard deviation, portfolio risk, portfolio return, portfolio beta
Which one of the following is a good example of diversification?
Holding 100 randomly picked financial assets
The inputs useful to estimate required rate of return with CAPM are ______
Risk-free rate, market expected return, market risk premium, beta, systematic risk
If a market is in an equilibrium, _____ will lie on the Security Market Line.
The market portfolio, the large company stocks, the small company stocks, the bonds, and the T-bills
Of the options listed below, which is the best measure of systematic risk?
beta
Portfolio
collection of assets
CAPM
defines the relationship between risk and return
Risk Premium Equation
expected return - risk free rate
The slope of the security market line is the:
market risk premium
Given a well-diversified stock portfolio, the variance of the portfolio:
may be less than the variance of the least risky stock in the portfolio
Risk and Risk-aversion
measures variance or standard deviation of the asset's return
In equilibrium, all assets and portfolios
must have the same reward-to-risk ratio, and they all must equal the reward-to-risk ratio for the market
Buchi owns several financial instruments: stocks issued by seven different companies, plus bonds issued by four different companies. Her investments are best described as a(n):
portfolio
To calculate the expected risk premium on a stock, one must subtract the ________ from the stock's expected return.
risk-free rate
Of the options listed below, which are examples of diversifiable risk?
Wildfires damage an entire town and all software providers are required to improve their privacy standards
Rules for Systematic Risk
a beta = 1, asset has the same systematic risk as the market. a beta < 1, asset has less systematic risk than the market. a beta > 1, asset has more systematic risk than the market
Diversification
portfolio diversification is the investment in several different asset classes or sectors
Reward-to-Risk ratio
relationship between the risk premium and beta. Risk premium divided by beta
Security Market Line
representation of the market equilibrium, demonstrate the relationship between beta and expected return
Systematic Risk
risk for being in the market, cannot be diversifies away, market/non diversifiable risk
Unsystematic Risk
risk specific to each stock, can be diversified away, firm-specific/diversifiable risk
Diversification can
substantially reduce the variability of returns without an equivalent reduction in expected returns
Total Risk
systematic risk + unsystematic risk
Risk-return trade off
the higher the beta, the higher expected return, the greater the risk premium
Risk
the potential of a loss
Risk Premium
the required reward for bearing risk (systematic)
An analyst wishes to estimate the amount of additional reward she will receive for investing in a risky asset rather than a risk-free asset. The minimum values she will need to know are:
the risky asset's beta and the market risk premium
Standard Deviation
treat the portfolio as one asset
Diversification is effective to reduce
unsystematic risk, firm-specific risk, and industry specific risk
The expected return of a stock, based on the likelihood of various economic outcomes, equals the:
weighted average of the returns for each economic state.
