Module 9 - Introducing Risk and Return

Variance

is a statistical concept describing the range around expected return within which an investment return can be reasonably expected to fall.

Systematic Risk

is intrinsic to the market, and thusly diversification has no effect on its presence in investments.

The debate over active vs passive management

is one that takes on the limits to diversification.

The general progression in the risk-return spectrum is: short-term debt

long-term debt, property, high-yield debt, and equity.

What type of risk can an investor reduce through the process of diversification?

Unsystematic risk can be reduced through diversification.

When a firm makes a capital budgeting decision

, they will wish, as a bare minimum, to recover enough to pay the increased cost of goods due to inflation

Which prediction based on a description of the yield curve is correct?

A normal yield curve suggests that interest rates will be raised in the future. An inverted yield curve suggests that interest rates will be dramatically cut. A flat yield curve suggest that interest rates will be cut.

Variable Rate Mortgage

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.

Which answer is a factor that influences market interest rates?

Deferred consumption, Inflationary expectations and Alternative investments

Diversification is not putting all your eggs in one basket.

Diversification relies on the lack of a tight positive relationship among the assets returns, and works even when correlations are near zero or somewhat positive.

What is Variance?

In finance, variance is a term used to measure the degree of risk in an investment. It is calculated by finding the average of the squared deviations from the mean rate of return.

Diversification

In general, diversification can reduce risk without negatively impacting expected return.

Expected Return

In probability theory, the expected value of a random variable is the weighted average of all possible values.

Which option is an adequate method to reduce an investor's risk through diversification?

Invest in a broad pool of US and international stocks and bonds. Risk can be diversified away by investing in a broad pool of assets.

In the market crash of 2008, investors feared that some home owners would default.

It triggered a chain of events that shocked the whole world and left many people in bad financial situations.

Often the risks interact with each other and ultimately shock causes panic.

Many of the worst market crashes have been a result of widespread speculation and not the devaluation of that asset itself.

Which answer is a cost to the investor that is included in the calculation of an investment's interest rate?

Opportunity Cost, Risk of a bad investment and Inflation

A company issues a bond with the provision that it may pay off the debt early. Which type of risk is this bond subject to?

Prepayment risk The buyer of the bond will lose the right to future interest payments if the company pays off the debt early.

You are considering investing in the common stock of a major US Corporation. Which answer is an example of systematic risk?

Risk resulting from a general decline in the US stock markets This illustrates a risk exposure that affects all companies in the market and is thus an example of systematic risk.

The most common measure of risk in finance is the

Standard deviation is the most common measure of risk in finance.

The risk that remains after an investor has extensively diversified his portfolio is primarily

Systematic risk is the portion of risk in a portfolio that cannot be diversified away.

Which statement accurately describes systematic risk?

Systematic risk is what provides a stock's "risk premium." Systematic risk is priced in the market since it is undiversifiable.

Expected return

The expected return of a potential investment can be computed by computing the product of the probability of a given event and the return in that case and adding together the products in each discrete scenario.

Expected value

The expected value of a random variable is the weighted average of all possible values that this random variable can take on.

Risk & Return

The higher the risk undertaken, the more ample the expected return-and conversely, the lower the risk, the more modest the expected return

Standard deviation

The standard deviation of an investment is obtained by taking the square root of the variance. It has a more straightforward meaning than variance. It tells you that in a given year, you can expect an investment's return to be one standard deviation above or below the average rate of return.

Risk

There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk

Unsystematic risk

Unsystematic or diversifiable risk is a term given to the portion of risk in a portfolio that can be diversified away by holding a pool of individual assets.

Which of the following describes the relationship between present value and future value?

When one increases, the other increases, assuming all variables are constant. A higher cash flow today would result in a higher amount in the future and vice versa.

Expected value is a concept that the helps

investors assess the value of a potential investment based on different future outcomes and a probability for each outcome.

In order to make investment decisions

investors often estimate the expected return of a potential investment.

Inflation

an increase in the general level of prices or in the cost of living.

Variance is calculated by calculating an expected return

and summing a weighted average of the squared deviations from the mean return.

Unsystematic risk does not factor?

into an investment's risk premium, since this type of risk can be diversified away

Financial risk is associated to the

chances that an investor might lose value in an investment. It is separated into different sources of decline.

Beta is a measure

firms can use in order to determine an investment's return sensitivity in relation to overall market risk.

Any investment should be made taking time considerations and

risk tolerance into account. If there is a specific deadline for when the investment needs to be matured (i.e., to generate retirement income, pay for a down payment on a house, college tuition) then caution is required.

What is Systematic risk

systematic or non-diversifiable risk is a term given to the portion of risk in a portfolio that cannot be diversified away by holding a pool of individual assets and therefore commands a return in excess of the risk-free-rate.

Risk aversion is a concept based on

the behavior of firms and investors while exposed to uncertainty to attempt to reduce that uncertainty

Diversification is a technique for reducing risk that relies on

the lack of a tight positive relationship among the returns of various types of assets

Political risk

the potential loss for a company due to nonmarket factors as macroeconomic and social policies.

Systematic risk

the risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta.

The role of diversification is

to narrow the range of possible outcomes

Once you have categories for different scenarios, along with probabilities and returns in each scenario

you then calculate your expected return by multiplying each probability by its respective outcome and adding these all together.

Three different asset classes

—stocks, bonds, money markets—range from aggressive, to moderate, to conservative. An investment that is aggressive typically features a higher expected return, but also a higher variance.