FIN 351 CH 13

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CAPM Factors affecting expected return

1. Pure TVM: measured by risk-free rate 2. Reward for bearing systematic risk: measured by the MRP 3. Amount of systematic risk: measured by beta

Expected Return

weighted average of the returns of the individual assets in the portfolio

Variance

weighted squared deviation from expected return for each scenario

Of the options listed below, which is the best example of unsystematic risk?

A national decrease in consumer spending on entertainment

Which one of the following statements is accurate?

A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio

The use of weighted average is applicable to estimate future ____

Expected return, standard deviation, portfolio risk, portfolio return, portfolio beta

Which one of the following is a good example of diversification?

Holding 100 randomly picked financial assets

The inputs useful to estimate required rate of return with CAPM are ______

Risk-free rate, market expected return, market risk premium, beta, systematic risk

If a market is in an equilibrium, _____ will lie on the Security Market Line.

The market portfolio, the large company stocks, the small company stocks, the bonds, and the T-bills

Of the options listed below, which is the best measure of systematic risk?

beta

Portfolio

collection of assets

CAPM

defines the relationship between risk and return

Risk Premium Equation

expected return - risk free rate

The slope of the security market line is the:

market risk premium

Given a well-diversified stock portfolio, the variance of the portfolio:

may be less than the variance of the least risky stock in the portfolio

Risk and Risk-aversion

measures variance or standard deviation of the asset's return

In equilibrium, all assets and portfolios

must have the same reward-to-risk ratio, and they all must equal the reward-to-risk ratio for the market

Buchi owns several financial instruments: stocks issued by seven different companies, plus bonds issued by four different companies. Her investments are best described as a(n):

portfolio

To calculate the expected risk premium on a stock, one must subtract the ________ from the stock's expected return.

risk-free rate

Of the options listed below, which are examples of diversifiable risk?

Wildfires damage an entire town and all software providers are required to improve their privacy standards

Rules for Systematic Risk

a beta = 1, asset has the same systematic risk as the market. a beta < 1, asset has less systematic risk than the market. a beta > 1, asset has more systematic risk than the market

Diversification

portfolio diversification is the investment in several different asset classes or sectors

Reward-to-Risk ratio

relationship between the risk premium and beta. Risk premium divided by beta

Security Market Line

representation of the market equilibrium, demonstrate the relationship between beta and expected return

Systematic Risk

risk for being in the market, cannot be diversifies away, market/non diversifiable risk

Unsystematic Risk

risk specific to each stock, can be diversified away, firm-specific/diversifiable risk

Diversification can

substantially reduce the variability of returns without an equivalent reduction in expected returns

Total Risk

systematic risk + unsystematic risk

Risk-return trade off

the higher the beta, the higher expected return, the greater the risk premium

Risk

the potential of a loss

Risk Premium

the required reward for bearing risk (systematic)

An analyst wishes to estimate the amount of additional reward she will receive for investing in a risky asset rather than a risk-free asset. The minimum values she will need to know are:

the risky asset's beta and the market risk premium

Standard Deviation

treat the portfolio as one asset

Diversification is effective to reduce

unsystematic risk, firm-specific risk, and industry specific risk

The expected return of a stock, based on the likelihood of various economic outcomes, equals the:

weighted average of the returns for each economic state.


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