Ch 8: Ris and Rates of Return

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What's Investment X's coefficient of variation? a. 0.85 b. 0.93 c. 1.07 d. 1.26 e. 1.18

0.85

Large cap Companies

Large cap company like, down jones, s&p 500, Walmart, Exxon, 3m, or Goldman Sachs, Cheveron, General Motors.

Probability Distrubition

Listings of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome.

The weights in the expected rate of return calculation must sum to equal: a. The expected rate of return. b. One hundred. c. The current real market interest rate. d. One.

One

risk aversion Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

Small cap Comapies

Smaller, younger companies.

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.

Risk

The chance that some unfavorable event will occur.

risk premium (RP)

The difference between the expected rate of return on a given risky asset and that on a less risky asset.

In calculating the expected rate of return, the expected returns in each state are weighted by: a. The time it takes to earn that return. b. The rate of return expected. c. The after tax rate of return earned. d. The probability of that state occurring.

The probability of that state occurring.

expected rate of return, r^

The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results.

Stand Alone Risk

The risk an investor would face if he or she held only one asset.

market risk

The risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as nondiversifiable or systematic or beta risk.

relevant risk

The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market.

coefficient of variation (CV) The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

People differ with regard to their willingness to bear risks. However, if two stocks have the same expected rate of return, then most individuals would prefer the less risky to the more risky stock. This is called risk aversion. True or false?

True

The coefficient of variation is a better measure of risk if one is comparing assets that have substantially different expected returns, because it shows the amount of risk per unit of expected return. True or false?

True

The probability distribution for a stock would list the stock's set of possible returns and the probability of each return. We could use this data to find both the stock's expected rate of return and the standard deviation of that return, which is one measure of risk. True or false?

True

There is a fundamental trade-off between risk and return: to entice investors to take on more risk, you have to provide them with higher expected returns.

True The higher the risk the better the return, the lower the risk the less return.

average stock's beta

by definition (b subscript a = 1) , because an average-risk stock is one that tends to move up and down in step with the general market.

standard deviation, σ

A statistical measure of the variability of a set of observations. how far from the actutal return is likely to deviate from the expected return.

Inflation rate between 1926 - 2009

Average at 3.1% per year.

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What's Investment X's standard deviation?

9.6%

beta coefficient, b

A metric that shows the extent to which a given stock's returns move up and down with the stock market. Beta measures market risk.

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What is X's expected return?

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What is X's expected return? Probability Return Prob x Ret. 25.000% 20.000% 5.000% 50.000% 15.000% 7.500% 25.000% -5.000% -1.250% Expected return = 11.250%