Finance Final Exam Chapter 11

What is unsystematic risk? What is another name for it? List an example

-A risk that affects a small number of assets (at most) -Also called "unique risk" and "asset-specific risk" -Ex: The announcement of an oil strike by a company will primarily affect that company and perhaps a few others

What is systematic risk? What is another name for it? List a few examples

-A risk that influences a large number of assets -Also called "market risk" -Ex: Uncertainties about general economic conditions (such as GDP), interest rates, and inflation

What are the two characteristics of unexpected returns?

-Comes about because of unanticipated events -The risk of investing stems from the possibility of an unanticipated event

True or false: systematic risk can be eliminated by diversification

-False, systematic risk cannot be eliminated by diversification -This is because a systematic risk affects almost all assets to some degree

How does diversification work?

-If an investor holds only a single stock, then the value of our investment would fluctuate only because of company-specific events -However, if an investor has a large portfolio, some of the stocks in the portfolio will go up in value because of positive company-specific events and some will go down in value because of negative events -The net effect on overall value (in the case of the portfolio) should be small, and will therefore cancel each other out

What is unique about the reward to risk ratio in a well functioning market? How does this relate to the security market line?

-In a well functioning market, this ratio is the same for every asset -As a result, when asset expected returns are plotted against asset betas, all assets plot on the same straight line (called the Security Market Line)

What is the systematic risk principle?

-This principle says that the expected return on a risky asset depends only on that asset's systematic risk -Another way of putting this is to say: "No matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset

List and explain 3 different common values for beta coefficients

1: By definition, an average asset has a beta of 1 relative to itself 2: An asset with a beta of .5 has half as much systematic risk as an average asset, and an asset with a beta of two has twice as much 3: A risk free asset has a beta of 0

How do we calculate the variances of the returns on two stocks?

1: Determine the squared deviations from the expected returns 2: Then, we multiply each possible squared deviation by its probability 3: We add these up, and the result is the variance 4: The standard deviation is the square root of the variance

What are the two parts of an announcement?

1: Expected part 2: Surprise

What are the two components of total return?

1: Expected return 2: Unexpected return

What are the two types of surprises associated with an announcement?

1: Systematic Risk 2: Unsystematic Risk

The return on any stock traded in a financial market is composed of two parts. What are they?

1: The normal/expected return from the stock is the part of the return that shareholders in the market predict or expect 2: The uncertain/risky return (the portion that comes from unexpected information revealed within the year)

According to the capital asset pricing model, what three things does the expected return for a particular asset depend on?

1: The pure time value of money 2: The reward for bearing a systematic risk 3: The amount of systematic risk

What is a portfolio?

A group of assets such as stocks and bonds held by an investor

What are portfolio weights?

A percentage of a portfolio's total value in a particular asset

What is the beta coefficient?

Amount of systematic risk present in a particular risky asset relative to that in an average risky asset

What is the expected return on a security or other asset equal to?

In general, the expected return on a security or other asset is simply equal to the sum of the possible returns multiplied by their probabilities

There is a minimum level of risk that cannot be eliminated by diversifying. What is the name for this risk?

Nondiversifiable risk

What is an expected return?

Return on a risky asset expected in the future

What is the principle of diversification?

Spreading an investment across a number of assets will eliminate some risk, but not all of it

What phenomenon explains why companies can make similar announcements but experience different stock price reactions?

The fact that only the unexpected/surprise portion of an announcement matters is the reason for this

What does the beta coefficient represent?

The level of systematic risk in a particular asset (relative to the average risk of an asset)

What is the surprise part of an announcement?

The news that influences the unanticipated return on the stock, U

What is the expected part of an announcement?

The part of the information that the market uses to form the expectation, E(R), of the return on the stock

How is the total risk of an investment measured?

The total risk of an investment is measured by the variance, or (more commonly), the standard deviation of its return

What is an unsystematic risk?

These are unanticipated events that affect single assets or small groups of assets

What is the "the reward for bearing a systematic risk" component of the capital asset pricing model?

This component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting

What is the "the amount of systematic risk" component of the capital asset pricing model?

This is the amount of systematic risk present in a particular asset (relative to an average asset)

What is the reward to risk ratio?

This is the ratio of an asset's risk premium to that asset's beta

What is the "pure time value of money" component of the capital asset pricing model?

This is the reward for simply waiting for your money

What does the systematic risk principle say?

This states that the reward for bearing risk depends only on the level of systematic risk

True or false: The marginal benefit that we get (in terms of reducing risk) from adding securities drops off incrementally as we add more and more securities

True

What is a systematic risk?

Unanticipated events that affect almost all assets to some degree because the effects are felt across the entire economy

Which part of risk is eliminated by diversification?

Unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk

What effect does diversification have on systematic and unsystematic risk?

Unsystematic risks tend to be washed out with diversification, but systematic risks do not