Chapter 3: Risk & Return Part 2

0.67(Historical Beta) + 0.35(1.0) =?

Adjusted Beta

____________________ grew largely out of the work of Marshall E. Blume, who showed that true betas tend to move toward 1.0 over time. Therefore, we can begin with a firm's pure historical statistical beta, make an adjustment for the expected future movement towards 1.0, and produce a(n)________________ that will, on average, be a better predictor of the future beta than the unadjusted historical beta would be.

Adjusted Beta

The ___________________ is based on complex mathematical and statistical theory, but can account for several factors (such as GNP and the level of inflation) in determining the required rate of return for a particular stock.

Arbitrage Pricing Theory (APT)

__________________ is an approach to measuring the equilibrium risk/return relationship for a given stock as a function of multiple factors, rather than the single factor (the market return) used by the CAPM.

Arbitrage Pricing Theory (APT)

Most people don't behave rationally in all aspects of their personal lives, and _________________ assumes that investors have the same types of psychological behaviors in their personal financial lives as in their personal lives.

Behavioral Finance

______________ is measured as systematic risk (nondiversified risk) of an asset relative to that of the market.

Beta

The following are the assumptions of the ________________: 1. Investors make their investment decision on the base of single holding periods. 2. There is no restriction on short sales of any securities. Investors can buy and sell any number of risk free securities. 3. There is no transaction cost on the purchase and sale of any securities. 4. All investors interpret the market in the same manner 5. There is no tax on purchase and sale of any securities.

Capital Asset Pricing Model (CAPM)

____________________ establishes a linear relationship between the required rate of return and the risk factor. In other words, it explains the trade-off between risk and return in any financial market.

Capital Asset Pricing Model (CAPM)

A(n)______________ is formed on an efficient set of risk-free and risky securities. The combination of risk free and risky securities forms an optimum portfolio.

Capital Market Line (CML)

A(n)________________ specifies a linear relationship between expected returns and risk of any efficient portfolio.

Capital Market Line (CML)

The _______________ specifies the efficient set of portfolios an investor can attain by combining a risk free asset and the risky market portfolio M. It states that the expected return on any efficient portfolio is equal to the riskless rate plus a risk premium, and thus describes a linear relationship between expected return and risk.

Capital Market Line (CML)

The ________________ for a particular stock is obtained by regressing the historical returns on that stock against the historical returns on the general stock market. Its slope is the stock's beta, which measures the amount by which the stocks expected return increases for a given increase in the expected return on the market.

Characteristic Line

_________________ is a measure of the linear relationship between two assets. It can be determined by dividing covariance by the standard deviations of the return of the security.

Correlation

The value of correlation is called a ___________________.

Correlation Coefficient

___________________ calculates relation in the movement of two assets.

Covariance

The __________________ is the set of efficient portfolios out of the full set of potential portfolios. On a graph, the _____________ constitutes the boundary line of the set of potential portfolios.

Efficient Frontier

A(n)________________ is one that offers the most return for a given amount of risk or the least risk for a given amount of return.

Efficient Portfolio

A(n)________________ is the selection of the best securities that eliminate all unsystematic risk. As a result, only systematic risk remains in the portfolio.

Efficient Portfolio

_________________ is defined as maximum return for a given level of risk or minimum risk for a given level of return.

Efficient Portfolio

A Security Market Line shows a relationship between risk and return in an efficient portfolio, while a Capital Market Line shows a relation between risk and return in individual securities

F

The ____________ of portfolios represents all portfolios that can be constructed from a given set of assets.

Feasible Set

A(n)__________________ is the risk/return trade-off function for a particular investor and reflects that investor's attitude towards risk. It specifies an investor's required rate of return for a given level of risk. The greater its slope, the greater is the investor's risk aversion.

Indifference Curve

The systematic relationship between the return on a security and the return on the market can be described by a ______________.

Linear Regression

The _________________ for an investor is defined by the investor's highest possible indifference curve that is tangent to the efficient set of portfolios. This point marks the highest level of satisfaction an investor can attain given the set of potential portfolios.

Optimal Portfolio

A(n)_____________ is a selection of different securities that diversified unsystematic risk.

Portfolio

In the Capital Asset Pricing Model, the expected rate of return is the return an investor expects in the near future, and the _____________ is the MINIMUM RETURN that inspires an investor to purchase it.

Required Rate of Return

Security A has an expected rate of return of 6%, a standard deviation of returns of 30%, a correlation coefficient with the market of -0.25, and a beta coefficient of -0.5. Security B has an expected return of 11%, a standard deviation of returns of 10%, a correlation with the market of 0.75, and a beta coefficient of 0.5. In a single asset portfolio, ___________ would be more risky.

Security A

Security A has an expected rate of return of 6%, a standard deviation of returns of 30%, a correlation coefficient with the market of -0.25, and a beta coefficient of -0.5. Security B has an expected return of 11%, a standard deviation of returns of 10%, a correlation with the market of 0.75, and a beta coefficient of 0.5. Which security is less risky if held in a diversified portfolio?

Security A: Lower beta and Negative Correlation with other stocks.

A(n)________________ is the graphical representation of the capital asset pricing model. It represents individual securities in the market.

Security Market Line

A capital market line shows a relationship between risk and return in an efficient portfolio, while a Security market line shows a relation between risk and return in individual securities.

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Empirical studies show a positive relationship between the beta and return in the Capital Asset Pricing Model.

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If there is only one security in a portfolio, then there will be no correlation formed in the portfolio.

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Simply put, co-variance and correlation measure how two variables are related to each other.

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There are two types of betas for used to calculate future systematic risk: Adjusted betas and Fundamental Betas

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When a company has a lot of undiversified investments, it can result in higher risk. This increase in risk will in turn increase the company's cost of capital

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