4.53 Portfolio Risk and Return: Part II

What is the equation for Beta?

(covariance of Asset i's return with the market return)/ (variance of the market return)

How many stocks in a portfolio does it take to achieve 90% of the maximum diversification possible?

12-18 stocks

Investors who believe market prices are informationally efficient often follow what kind of investment strategy?

A passive investment strategy

What is a simplifying assumption underlying modern portfolio theory?

A simplifying assumption underlying modern portfolio theory is that investors have homogeneous expectations (they all have the same estimates of risk, return, and correlations with other risky assets for all risky assets).

Under the simplifying assumption underlying modern portfolio theory, all investors face what?

All investors face the same efficient frontier of risky portfolios and will have the same optimal risky portfolio and CAL.

All points on the CML represent what?

All points on the CML represent the risk-return characteristics of portfolios formed by either combining the market portfolio with the risk-free asset or borrowing at the risk-free rate in order to invest more than 100% of the portfolio's net value int he risky market portfolio.

Unsystematic risk is not compensated in equilibrium why?

Because it can be eliminated for free through diversification.

If you think about the costs of a no-load index fund compared to buying individual stocks, diversification is actually what?

Diversification is actually very low cost if not actually free.

Return generating models are used to estimate the expected returns on risky securities based on what?

Expected returns on risky securities based on specific factors.

The sensitivity of security returns depend on what 3 factors according to Fama and French?

Firm size; firm book value to market value ratio; return on market portfolio minus the risk-free rate

Higher Sharpe ratios indicate what?

Higher Sharpe ratios indicate better risk-adjusted portfolio performance.

What is a passive investment strategy?

Invest in an index of risky assets that serves as a proxy for the market portfolio and allocate a portion of their investable assets to a risk-free asset, such as short-term government securities.

The slope of the least squares regression line equals what?

It is an estimate of beta.

What does it mean for a firm to have high systematic risk?

It means that the firm is very responsive to market or systematic changes.

According to capital market theory, a stock with more total risk has less systematic risk and therefore will have what?

It will have lower equilibrium rate of return

The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets is referred to as what?

It's referred to as the "capital allocation line" (CAL).

Examples of firms that are highly correlated with market returns are what?

Luxury goods manufacturers such as Ferrari automobiles and Harley Davidson motorcycles.

Factors that can explain security returns can be classified in what 3 categories?

Macroeconomic, fundamental, and statistical factors.

Multifactor models most commonly use what?

Multifactor models most commonly use macroeconomic factors such as GDP growth, inflation, or consumer confidence along with fundamental factors such as earnings, earnings growth, firm size, and research expenditures.

Do you have to buy all the securities in the market to diversify away unsystematic risk?

No

Does bearing nonsystematic risk increase expected returns?

No, bearing nonsystematic risk does not increase expected returns.

Will investors be compensated for bearing risk that can be eliminated at no cost?

No, investors will not be compensated for bearing risk that can be eliminated at no cost.

Does the riskiest stock necessarily mean the greatest expected return?

No, the riskiest stock does not necessarily mean the greatest expected return. Case-in-point: biotech stocks.

What is an important conclusion of capital market theory?

One important conclusion is that equilibrium security returns depend on a stock's or portfolio's systematic risk, not its total risk as measured by standard deviation.

Total risk can be broken down into what 2 component parts?

Systematic and unsystematic risk

What is systematic risk? (2)

Systematic risk is nondiversifiable or market risk.

What is systematic risk? (2)

Systematic risk is nondiversifiable risk

What is systematic risk?

Systematic risk is risk which cannot be reduced by further diversification.

The CAPM is an equilibrium model that predicts what?

The CAPM predicts the expected return on a stock given the expected return on the market, the stock's beta coefficient, and the risk-free rate.

What is the M-squared measure?

The M-squared measure produces the same portfolio rankings as the Sharpe ratio but is stated in percentage terms.

What is the Sharpe ratio of a portfolio?

The Sharpe ratio of a portfolio is its excess returns per unit of total portfolio risk.

What are 2 measures of risk-adjusted return based on systematic risk rather than total risk?

The Treynor measure and Jensen's alpha.

A model assumption that diversification is costless leads to which conclusion?

The assumption that diversification is costless leads to the conclusion that only systematic risk is priced in equilibrium

The best CAL is the one that offers what?

The best CAL is the one that offers the most-preferred set of possible portfolios in terms of their risk and return.

Systematic risk is measured by the contribution of a security to the risk of a well diversified portfolio and the expected equilibrium return on an individual security will depend on what?

The individual security will depend on its systematic risk.

What is the "least squares regression line"?

The least squares regression line is the line that minimizes the sum of the squared distances of the points plotted from the line.

What is the market model?

The market model is a single factor model where the only factor is the expected excess return on the market portfolio.

What is the market risk premium?

The market risk premium is the difference between the expected return on the market and the risk-free rate.

When an investor diversifies across assets that are not perfectly correlated, the portfolio's risk is less than or more than the weighted average of the risks of the individual securities in the portfolio?

The portfolio's risk is less than the weighted average of the risks of the individual securities in the portfolio.

The risk that is eliminated by diversification is called what risk?

The risk that is eliminated by diversification is called "unsystematic" risk.

The high risk of our biotech stocks is from firm-specific factors, so its unsystematic risk is high or low?

The unsystematic risk is high.

Because the SML shows the equilibrium (required) return for any security or portfolio based on its beta, analysts often compare their forecast of a security's return to what?

To its required return based on its beta risk.

In equilibrium, a security's expected return and its required return are equal: T/F?

True

What is the CML (Capital market line)

Under the assumption of homogeneous expectations, the optimal CAL for all investors is termed the CML.

What are other names for unsystematic risk?

Unique, diversifiable or firm-specific risk

Total risk can be broken down into what 2 component parts? (2)

Unsystematic risk and systematic risk

Do utility companies respond a lot or a little to changes in the systematic risk factors?

Utility companies respond very little to changes in systematic risk factors.

The value of the Sharpe ratio is only useful for comparison with what?

With the Sharpe ratio of another portfolio.

Does the Sharpe ratio use total risk?

Yes, the Sharpe ratio uses total risk

Once you get to 30 or more securities in a portfolio, does the standard deviation remain constant?

Yes, the standard deviation remains constant.