Chapter 7

calculating the BETA of a portfolio

B=Oim/O^2m

Expected Returns

E (rm) = risk-free-rate (rf) + expected risk premium

What does beta measure?

It measures the risk of a security in relation to the overall market.

What does beta measure?

It measures the risk of security in relation to the overall market.

What is the impact on market risk when securities are added to a portfolio?

It will not change.

Which of the following are examples of specific risk?

Labor strikes Changes in the federal tax code Reason: Changes in the federal tax code are systematic risks that affect a large number of companies. The expected rate of inflation next year Reason: Unsystematic risk affects a single or small group of assets. Inflation is a systematic risk that affects a large number of companies. Changes in management Correct Answer Labor strikes Changes in management

r sub m

Market Return

Which type of risk does not change as we add more securities to a portfolio?

Market risk

Two Reason history may overstate the risk premium that investors demand today:

Reason 1: By Focusing on Equity Reutrns in the united states we may obtain a biased view of what investors expected. Reason 2: Economsits who believe that history may over state the return that investors expect often point to the fact that stock prices have for some years outpaced

What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? The expected returns are 7 percent, -3 percent, and 18 percent, respectively.

Reason: .5 × 7% + .3 × -3% + .2 × 18% = 6.2% 6.2% Correct Answer 6.2%

What is Stock B's beta if the covariance between stock B and the market is 3.75, and variance of the market is 2.5?

Reason: 3.75/2.5 = 1.5 Correct Answer 1.5

Risk Aversion Assumption

The Increase in utility is not as large when you have higher amounts of money.

All of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B, except

The variances of stocks A and B The covariance between stocks A and B The market value, in dollars, of the investments in stocks A and B The variance of the stock market index Reason: The variance of the stock market index is not required to compute the variance of a portfolio consisting of any two stocks. Correct Answer The variance of the stock market index

Rank the following in order from the lowest variance to the highest variance over the time period from 1900-2014.

Treasury Bills Us Security Stocks

The ____________ is the difference between risky returns and risk-free returns.

risk premium

The risk premium is the difference between risky returns and ______ returns.

risk-free

Studying market history can reward us by demonstrating that:

there is a reward for bearing risk the greater the potential reward is, the greater the risk

uWhen we have more that one asset (i.e. a portfolio) risk and return are more complex. We will show that there are two kinds of risk:

uDiversifiable/idiosyncratic/nonsystematic risk uNondiversifiable/systematic risk uWe can eliminate diversifiable risk by carefully combining assets into portfolios.

•More often, we rely on parameters of the probability distribution (think normal) to summarize the important information. These include:

•The expected value, which is the mean of the distribution. •The variance or standard deviation, which are measures of the dispersion of possible outcomes around the mean.

From 1900 to 2014, the U.S. had the world's ______ highest market risk premium.

8th

Holding Period Return

=(1+R1)x(1=R2)x....x(1+Rn)-1

Moral of Arthmetic Averages and Compound Annual Returns

if the cost of capital is estimated from historical returns or risk premiums, use Arithmetic averages, not compound annual rates of return.

Covariance

is a measure of the degree to which two

Oim

is the co variance between the stock returns and the market returns.

Compound annual averages are usually ______ arithmetic averages.

less than

The variance of the return on a portfolio with many securities is _______ dependent on the covariances between the individual securities than on the variances of the individual securities.

more less Reason: The variance of the return on a portfolio with many securities is more dependent on the covariances between the individual securities than on the variances of the individual securities because there are so many covariance terms. Correct Answer more

Nonsystematic/diversifiable risks

•Examples -What is the quality of the ore at a gold mine? -Lawsuits -Narrow Technological innovations -Factory specific strikes, -etc. - •The key is that these events are random and unrelated across firms. Some surprises are positive, some are negative. On average, the surprises offset each other

If Inflation is I than the real risk Premium is

(Rm-Rf)/(1+i) (Countries such as Itialy that experience a high degree of inflation, real risk premium may be significantly lower than the nominal premium.

What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both the stocks. Multiple choice question.

12.5%

A firm faces many risks. Which of the following are examples of specific risks faced by a firm?

A hostile takeover attempt by a competitor The death of the CEO

What is variance?

A measure of the squared deviations of a security's return from its expected return

arithmetic mean

An average that is calculated by adding up a set of quantities and dividing the sum by the total number of quantities in the set. •reflects the mean in any given year It provides an estimate of the expected return in any given year.

A firm is exposed to both market and specific risks. Which of the following are examples of market risks?

An increase in the Federal funds rate An increase in the corporate tax rate

Correlation is related to covariance. Correlation measures the interrelationship between the returns of two securities.

Correlation is related to covariance. Correlation measures the interrelationship between the returns of two securities.

Which of the following statements are true about correlation?

Correlation measures the interrelationship between the returns of two securities. The correlation between two securities remains constant over time. Reason: Correlation varies over time. Correlation is related to covariance. Correlation is not related to covariance. Reason: Correlation and covariance are related - correlation is standardized by the standard deviations of the two covariates. Correct Answer Correlation measures the interrelationship between the returns of two securities. Correlation is related to covariance.

PV=DIV1(r-g) is the Value of the Dividend.

Div1/PV=r-g is the dividend yeild/

True or false: Investors will pay extra for firms that diversify.

False Reason: They will not pay extra because they can diversify on their own.

The Arrhythmic Average is:

Higher than the compound annual return over the period.

What is specific risk?

It is a risk that affects a single asset or a small group of assets.

What is market risk?

It is a risk that threatens all businesses and cannot be diversified away.

As more securities are added to a portfolio, what will happen to the portfolio's total specific risk?

It is likely to decrease. It may eventually be eliminated.

Which of the following are examples of market risk? Multiple select question.

Labor strikes Reason: Labor strikes are an example of unsystematic risk. Future rates of inflation An increase in competition in the industry Reason: Competition within an industry is an example of unsystematic risk. Regulatory changes in tax rates Correct Answer Future rates of inflation Regulatory changes in tax rates

Real risk Premium is the difference between the real market return and the real interest rate.

Nominal Market Return VS Nominal Interest Rate

If the variance of a portfolio increases, then the portfolio standard deviation will _____.

Reason: If the variance of a portfolio increases, then the portfolio standard deviation will also increase, because the standard deviation is the square root of the variance. Correct Answer increase

Answer Mode Multiple Choice QuestionYour Answer correct If the variance of a portfolio is .0025, what is the standard deviation?

Reason: σp= .0025.5= .05, or 5% Correct Answer 5%

Which of the following statements are true about variance?

Standard deviation is the square root of variance. Variance is a measure of the squared deviations of a security's return from its expected return. It's NOT the others because: Computation of variance requires the use of a computer. Reason: Variance can be computed without a computer, either by hand or calculator. Variance measures a security's expected return over many periods. Reason: Variance is an assessment of volatility, not return.

Which of the following are examples of specific risk?

The expected rate of inflation next year Reason: Unsystematic risk affects a single or small group of assets. Inflation is a systematic risk that affects a large number of companies. Labor strikes Changes in management Changes in the federal tax code Reason: Changes in the federal tax code are systematic risks that affect a large number of companies. Correct Answer Labor strikes Changes in management

What is the main purpose of holding a diversified portfolio?

To reduce total risk by spreading investment dollars across various assets To increase total return by spreading investment dollars across various assets Reason: While this might be the result, it is not the main goal. To reduce trading costs of the portfolio To meet SEC regulatory requirements Correct Answer To reduce total risk by spreading investment dollars across various assets

O^2m

Variance of the returns on the market

If stock GHI has returns of 10% and 15% over 2 years, the compound annual average rate of return can be calculated by:

[(1.10)(1.15)]0.5 -1

If stock GHI has returns of 10% and 20% over 2 years, the compound annual average rate of return can be calculated by:

[(1.10)(1.20)]0.5 -1

Diversification is possible as long as the correlation between securities is ____.

equal to +1 Reason: There are no diversification benefits if the correlation between securities is +1. less than +1 Reason: As long as the securities within the portfolio are not perfectly positively correlated, some diversification benefit is realized. more than 1 Reason: The correlation coefficient cannot exceed 1. Correct Answer less than +1

Geometric Mean

the mean of n numbers expressed as the n-th root of their product. •reflects the mean compounded return across years. •Use it if you intend to compound mean returns. • •The standard in the mutual fund industry is to report the geometric mean return --- but, if in doubt, inquire.

Beta

the sensitivity of a security's returns to the market factor

What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?

Reason: 1.5/2.5 = .6 Correct Answer .6

Standard deviation of those returns

The standard deviation is often denoted by σ

There are two main reasons to be concerned with this question. How are risk and expected return related?

(1) When saving/investing , what is the tradeoff between taking risks and our expected future wealth? (2) When conducting discounted cash flow analysis, how should we select discount rates that properly consider risk?

A firm is exposed to both market and specific risks. Which of the following are examples of market risks?

An increase in the corporate tax rate An increase in the Federal funds rate

Which of the following are examples of market risk?

Labor strikes Reason: Labor strikes are an example of unsystematic risk. An increase in competition in the industry Reason: Competition within an industry is an example of unsystematic risk. Future rates of inflation Regulatory changes in tax rates Correct Answer Future rates of inflation Regulatory changes in tax rates

Beta

On average is 1. If over one they amplify the movements of the market. If it is less then one they tend to move in the same direction of the market, but not as far. (Many Stocks that have a high standered deviation also have a high beta.)

The variance of the return on a portfolio with many securities is _______ dependent on the covariances between the individual securities than on the variances of the individual securities. Multiple choice question.

Reason: The variance of the return on a portfolio with many securities is more dependent on the covariances between the individual securities than on the variances of the individual securities because there are so many covariance terms. Correct Answer more

What is likely to happen to the total specific risk of a portfolio when we add new securities to a portfolio?

The total specific risk of the portfolio will decrease.

What is likely to happen to the total specific risk of a portfolio when we add new securities to a portfolio? Multiple choice question.

The total specific risk of the portfolio will increase. Reason: Total specific risk decreases as more securities are added to a portfolio. There will be no effect on the total specific risk. The total specific risk of the portfolio will decrease. Correct Answer The total specific risk of the portfolio will decrease.

Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B?

The variances of stocks A and B The market value, in dollars, of the investments in stocks A and B The covariance between stocks A and B The variance of the stock market index Reason: The variance of the stock market index is not required to compute the variance of a portfolio consisting of any two stocks. Correct Answer The variances of stocks A and B The market value, in dollars, of the investments in stocks A and B The covariance between stocks A and B

True or false: It is possible for the specific risk of a portfolio to be reduced to zero.

True

True or false: Market risk will impact all securities in a portfolio equally.

True Reason: While it is possible, it is highly unlikely that market risk (such as changes in interest rates) will affect all firms equally. False Correct Answer False

The average return on the stock market can be used to ___.

compare stock returns with the returns on other securities

Diversification is possible as long as the correlation between securities is ____.

less than +1 Reason: As long as the securities within the portfolio are not perfectly positively correlated, some diversification benefit is realized. equal to +1 Reason: There are no diversification benefits if the correlation between securities is +1. more than 1 Reason: The correlation coefficient cannot exceed 1. Correct Answer less than +1