Ch 6 Risk & Return FIN5200

Rate of Return =

(Amount Received - Amount Invested)/Amount Invested

Percentage Expected Return =

(Expected Dollar Return/Current Price) × 100

Suppose a stock sells for $800 and pays no dividends. At the end of one year, the stock's price decreases to $700. What is the dollar return on investment in this stock?

-$100.00 because Dollar Return = Amount to be Received - Amount Invested

To calculate the beta of another company, using regression analysis, you get the value of R² as 0.43. Based on your calculation, which of the following interpretations is true?

43% of the variance in the company's returns can be explained by the market returns.

You gave $770 to your cousin. As a token of gratitude, your cousin gave you $1,190 at the end of the year instead of $770. If you look at this as an investment, then your annual rate of return would be

54.55% because Rate of return = (Amount Received - Amount Invested)/Amount Invested

Which of the following investments generates a higher annual rate of return?

A $1,000 return on a $10,000 investment for 1 year because A $1,000 gain on a $10,000 investment generates a 10% ($1,000 / $10,000) annual rate of return.

A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation? A portfolio containing only Chevron stock A portfolio consisting of about 30 energy stocks A portfolio consisting of about 30 randomly selected stocks

A portfolio consisting of about 30 randomly selected stocks

The coefficient of variation is a measure of variability that scales the standard deviation by the expected return of an asset.

CV = Standard Deviation/Expected Return

The financial performance of an investment is best expressed as a:

Percentage, since it scales, or standardizes, the return earned from the investment by the investment's size.

A portfolio's beta is the weighted average of all the component stocks' betas. First, you need to calculate each stock's weight in the portfolio by dividing the investment in each stock by the total investment.

Portfolio Beta bp = w1b1 + w2b2 + ... + wnbn where bp must first be calculated—use the portfolio weights to calculate the portfolio's beta; For Example: bp=(0.35 x 0.90) + (0.20 x 1.90) + (0.15 x 1.20) + (0.30 x 0.30) =0.965

The security market line (SML) plots the results derived from the Capital Asset Pricing Model (CAPM), which is based on the proposition that a stock's required rate of return is equal to the risk-free rate plus a risk premium multiplied by the security's beta. You can calculate the portfolio's required return of stock i by plugging the portfolio beta into the SML equation:

Required Return on Stock iRequired Return on Stock i = = Risk-Free Return + (Market Risk Premium × Best of Stock i)

This type of risk relates to changes in the interest rate.

Systematic Risk

A portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk.

True

The unsystematic risk component of the total portfolio risk can be reduced by adding negatively correlated stocks to the portfolio.

True

True or false? According to research in the area of behavioral finance, the average risk averse investor perceives his or her gains and losses differently; that is, the utility derived from a $1,000 gain is not equal to the disutility associated with a $1,000 loss. According to this research, risk averse investors dislike or fear losses more than they enjoy gains.

True because risk, or outcome variability, can generate possible outcomes that are greater or less than a security's expected value, then risk can generate positive or negative results. In general, investors don't mind receiving actual results that exceed their expected value, such as actually receiving $125 when you expected to receive only $100, but they tend to respond more negatively when they receive $75 instead of the expected $100. This reaction is particularly true for risk averse investors. While both outcomes represent $25 deviations from the expected value of $100, investors will experience a stronger negative reaction to the loss of $25 than they will a positive reaction to the gain of $25.

This type of risk is inherent in a firm's operations.

Unsystematic risk

Risk is the potential for an investment to generate more than one return. A security that will produce only one known return is referred to as a risk-free asset, as there is no potential for deviation from the known expected outcome. Investments that have the chance of producing more than one possible outcome are called risky assets. Risk, or potential variability in an investment's possible returns, occurs when there is uncertainty about an investment's future outcome, such as the return expected to be generated by the investment and realized by an investor. As an investor and based on your understanding of risk, which of the following statements is true?

You should invest in a stock if the expected rate of return from the stock is greater than the expected rate of return on an asset with a similar risk.

Generally, investors would prefer to invest in assets that have:

a low level of risk and high expected returns.

Using the new weights, first calculate the portfolio's new beta as follows:

bp = the sum of the investment allocations each multiplied by their betas

it is not the magnitude of return that is important in this case, but the degree to which their movements are synchronized over time. This tendency to move together is measured by the asset's ______________, and assets that are _____________ generate returns that exhibit the identical pattern over time. In contrast, assets that are ____________ generate returns that exhibit the exactly opposite pattern.

correlation coefficient; perfectly positively correlated; perfectly negatively correlated

This can be used to reduce the stand-alone risk of an investment by combining it with other investments in a portfolio.

diversification

investors _________ receiving investment returns that exceed their expected return, but they tend to respond differently if the investment can generate a lower return.

don't mind

Another way of thinking about the risk-reduction benefits of diversification is to focus on the standard deviations of the assets. If the standard deviation of the returns of an asset being added to a portfolio is ____________ than the standard deviation of the portfolio's return, then the riskiness of the portfolio will increase, rather than decrease, which is contrary to the goal of diversification.

greater

If the amount to be received at the end of the investment period is ____________ the amount invested, the investment is said to have a positive return on investment.

greater than

the magnitude of the risk premium will ________ as the amount of risk exhibited by the investment increases. So the riskiest investments require the _________ risk premiums, and investments exhibiting relatively little risk require _________ risk premiums.

increase; greatest; small

If you're holding a portfolio of assets, on the other hand, then the risk that is of greater interest is the _________ riskiness, and how the addition of a new security or asset would affect the overall riskiness of the portfolio. This brings us to a related concept: the advantages and disadvantages of _____________

portfolio's; diversification

A listing of each possible outcome and the probability of each outcome occurring.

probability distribution

It should be noted, however, that during the period of 1968 to 1998, the correlation coefficient for most pairs of randomly selected U.S. companies was 0.28. This means that the addition of a randomly selected U.S. company to a portfolio of other U.S. corporations should ___________ the riskiness of the portfolio.

reduce

an appreciation of the relationship between the objective or outcome of your investment, that is its _________

return

the majority of investors, or those buying and selling securities, are assumed to be ___________. This does not mean that they won't purchase or sell risky securities or projects, it simply means that they ___________ be compensated with a risk premium or additional return for taking on projects or securities exhibiting additional risk.

risk adverse; must

If an investment has the potential to provide only one possible outcome or return, then it is

risk free

if there is more than one possible return or result, then the asset should be considered

risky

securities sold by the U.S. Treasury have historically been considered to be the ___________ securities in the world

safest

You invest $100,000 in only one stock. What kind of risk will you primarily be exposed to?

stand-alone risk

you can measure the riskiness of that investment by calculating the ____________ of the investment's possible returns.

standard deviation