HS 345 Chapter 10 Financial Risk and Required Return

A. What is the capital asset pricing model (CAPM)? The security market line (SML)? B. What are the weaknesses of the CAPM? C. What is the value of the CAPM?

CAPM: AN equilibrium model that specifies the relationship between a stock's value and its market rise as measured by beta. SML: The portion of the capital asset pricing model, that specifies relationship between market risk and required rate of return. B. Based on a very strict set of assumptions Hasn't been empirically verified Based on investor expectations but the inputs used are usually historically based C. Provides investors with a rational way of thinking about required rates of return. Tells us the required rate of return on an investment is composed of the risk free rate etc.

Assume that two investments are combined in a portfolio. A. In words, what is the expected rate of return on the portfolio? B. What condition must be present for the portfolio to have lower risk than the weighted average of the two investments? C. Is it possible for the portfolio to have lower risk than that of either investment? D. Is it possible for the portfolio to be riskless? If so, what condition is necessary to create such a portfolio?

A.What is the expected rate of return on the portfolio -It is the weighted average of the returns on the component investments b. What condition must be present for the portfolios to have lower risk than the weighted average of the two investments? -Standard deviation of the portfolio returns c. Is it possible for the portfolio to have lower risk than that of either investment? -Yes d. Is it possible for the portfolios to be riskless? -Yes If so, what condition is necessary to create such a portfolio? -Correlation: The two investments returns would need to move exactly opposition to one another

Explain why holding investments in portfolios has such a profound impact on the concept of financial risk.

Because the concern of the investors changes from the realized rate of return from an individual investment but on the entire portfolio. The riskiness of the portfolio as a whole is what becomes important.

What are the implications of portfolio theory for investors?

It's not rationale for an investor, whether an individual or business, to hold a single investment.

Explain the difference between portfolio risk and diversifiable risk.

Portfolio risk:is that part of the stand-alone risk that cannot be eliminated by diversification (cannot be diversified away) Diversifiable risk: portion of the stand-alone risk of an investment that can be eliminated by holding the investment in a portfolio

Under what circumstances is each type of risk—stand alone, corporate, and market—most relevant?

Stand Alone- if the investment is isolated Corporate- if the investor is a business Market-if the investor is an individual

Stock A has an expected rate of return of 8%, a standard deviation of 20%, and a market beta of 0.5. Stock B has an expected rate of return 12%, a standard deviation of 15%, and a market beta of 1.5. Which investment is riskier? Why? (Hint: Remember that the risk of an investment depends on its context.)

Stock A is risker because it has a higher standard deviation of expected returns than stock B.

When considering stand-alone risk, the return distribution of a less risky investment is more peaked ("tighter") than that of a riskier investment. What shape would the return distribution have for an investment with (a) completely certain returns and (b) completely uncertain returns?

a. Completely certain returns-tighter b. Completely uncertain returns-wider

A. What are the two types of portfolio risk? B. How is each type defined? C. How is each type measured?

a. Corporate risk, Market risk b.Corporate: Risk of business's projects when they're considered part of a business's portfolio of projects. Market: the risk of business projects (or of the stocks of entire businesses) where they're considered as part of an individual investor's well-diversified portfolio of securities

A. What is risk aversion? B. Why is risk aversion so important to financial decision making?

a. Risk Aversion: tendency of individuals and businesses to dislike risk. Risker investments must offer higher expected rates of return to be acceptable. b. Because this helps the company lose the least or make the most amount of money-when appropriate stick with low risk but if able go for a higher risk investment