Exam 2 Part of Ch. 8, 5, 7,

What is Market Risk Premium?

*slide 72* the additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk - rm (market risk rate of return) - rf (risk free rate of return) = risk premium - its size depends on the perceived risk of the stock market and investors' degree of risk aversion - varies from year to year, but most estimates suggest that it ranges between 4% to 8% per year

Interpreting Beta Beta of +2 1. if the market goes up 1%, stock expected to.. 2. if the market goes down 1% stock expected to.. 3. Beta of +1 moves _________ with market Beta of 0.5 4. if market goes up 1%... 5. if market goes down 1%... 6. Beta of 0 has _____________ with market

1. go up 2% (stock is twice as risky as the market) 2. goes down 2% ^^^ 3. 1 to 1 4. stock only goes up 0.5% 5. stock drops just 0.5% 6. NO correlation

An index fund will have a beta of 1.0. If Km is 12.0% (given in the problem) and the risk-free rate is 5%, you can calculate the market risk premium (RPm) calculated as Km - Krf as follows: K = Krf + (RPm)(b)

12.0% = 5% + [(RPm)1.0] *7.0%* = RPm

CHAPTER 5

CHAPTER 5

CHAPTER 7

CHAPTER 7

Two Components of Risk

Company-Specific (Diversifiable, Idiosuncratic, Un-systematic) Risk: - unique to specific firms - results from random or uncontrollable events ex. natural disasters accidents, strikes, lawsuits, death of CEO Market (Non-Diversifiable, Systematic) Risk: - relates to forces affecting all investments ex. inflation, recession, war, yield inversion, etc.

Is the postulated CAPM (Capital Asset Pricing Model) linear positive relationship, always so?

No, may lose all of your money on a stock, because; Realized Return /= Expected Return

Stock A has a beta of 1.0 and Stock B has a beta of 0.8. Which of the following statements must be true about these securities? (Assume the market is in equilibrium) a. When held in isolation, Stock A has greater risk than Stock B. b. Stock B would be a more desirable addition to a portfolio than Stock A. c. Stock A would be a more desirable addition to a portfolio than Stock B. d. The expected return on Stock A will be greater than that ton Stock B. e. The expected return on Stock B will be greater than that on Stock A.

*d. The expected return on Stock A will be greater than that ton Stock B.* a. (incorrect) - beta measures only market risk. in isolation, stand-alone risk measure could show either stock to be more risky since diversifiable risk is included. b. (incorrect) - stock B adds less market risk to the portfolio, but that does not mean that it is more desirable since investors would be compensated for the additional market risk of Stock A. c. (incorrect) -Stock A adds more market risk to the portfolio, but that does not mean that it is less desirable since investors would be compensated for the additional market risk. e. (incorrect) - in equilibrium, Stock A will have a higher expected return to compensate for the additional market risk .

Illustrating diversification effects of a stock portfolio (graph)

*graph* 8-56 - market risk CANNOT be taken away - the more stocks in your portfolio, the less risky ex. if you can't swim, you can't get rid of the risk of drowning no matter how deep, even tiptoeing into the water is risky graph shows; - market risk at a constant 20% of the standard deviation - company-specific risk changes (less # of stocks, more risky, more # of stocks, less risky)

Calculation of Beta

*slide 8-62* Ki = f (Km)

Capital Asset Pricing Model (CAPM)

*slide 8-70, 73* a model based on the proposition that any stock's required rate of return is = to the risk-free rate of return + a risk premium that reflects only the risk remaining after diversification (of stocks in the portfolio). - slope of the line is the risk premium - the SML is the line that represents the CAPM (risk of stocks held in portfolios) ex. SML: Ki = 8% + (15% - 8%) (bi) - slope here would be 7% (risk premium)

Portfolio Beta

*slide 8-80* a weighted average of the security betas (sum of weight x beta)

Security Market Line (SML)

*slides 8-70, 75 76* an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.

Changes in Security Market Line (SML) - Risk Premium

*slides 8-70, 75 76* impacts riskier stocks more - SML rotates - beta goes up, expected return goes up - as price drops, expected return goes up

Creating a Portfolio: Beginning with one stock and adding randomly selected stocks to portfolio (what happens?)

- standard deviation decreases as stocks added, because they would not be perfectly correlated with existing porfolio. - expected return of the portfolio would remain relatively constant - eventually the diversification benefits of adding more stock dissipates (after about 40 stocks), and for large stock portfolios, standard deviation tends to converge to about 20%.

Do most stocks have positive, negative, or zero correlations with each other?

Positive, but not perfectly so

Correlation Coefficient

Ranges from -1 to +1 comparing the correlation between securities (stocks, bonds, etc.) -1 = perfectly negative correlation +1 = perfectly positive correlation 0 = variables are not related

We know that Br = 1.50, Bs = 0.75, Km = 13%, Krf = 7%. Ki = Krf + (Km - Krf) (Bi)

So after plugging in the numbers; Ki = 7% + [(13% - 7%) (Bi)] 1. Ki = 7% + [6% (1.50)] = 16.0% ??? 2. Ki = 7% + [6% (0.75)] = 11.5% ??? 16.0 % - 11.5% = *4.5%*

What is the correlation of any security with riskless asset (hint: is a t-bill riskless)??

Zero

Which of the following statements best describes what would be expected to happen as you randomly add stocks to your portfolio? a. adding more stocks to your portfolio reduces the portfolio's company-specific risk. b. adding more stocks to your portfolio reduces the beta of your portfolio. c. adding more stocks to your portfolio increases the portfolio's expected return.

a. adding more stocks to your portfolio reduces the portfolio's company-specific risk. b. (incorrect) - market risk( which is measured by beta) can go up, down, or remain unchanged as new stocks are added. c. (incorrect) - expected return can go up, down, or remain unchanged as new stocks are added.

_____________________ is a measure of market risk which is the extent to which the retuns on a stock move with the market. a. beta b. standard deviation c. coefficient of variation d. expected return

a. beta d. (incorrect) - not even risk

For virtually all portfolios, the riskiness of the portfolio is a weighted average of the riskiness of the individual assets in the portfolio with the weights equal to the fraction of the total portfolio funds invested in each asset. a. true b. false

b. false a. (incorrect) - the riskiness of the portfolio is generally less than the weighted average risk fo the individual assets. Portfolio risk depends on the risk of the individual stocks and the correlation between stocks.

Which of the following statements are correct? a. diversifiable risk CAN be eliminated by proper diversification. b. market risk CANNOT be eliminated by proper diversification. c. the market portfolio has risk. d. all of the above are correct.

d. all of the above are correct.

Which of the following statements is correct? a. it is possible to have a situation in which the market risk of a single stock is less than the market risk of a portfolio of stocks. b. the market risk premium will increase if on average, market participants become more risk averse. c. if you selected a group of stocks whose returns are perfectly positively correlated, then you could end up with a portfolio for which none of the unsystematic risk is diversified away. d. all of the statement above are correct.

d. all of the statement above are correct.

The CAPM (Capital Asset Pricing Model) says that the relevant risk of an individual asset is its: a. stand-alone risk b. expected return c. realized return d. portfolio or market risk

d. portfolio or market risk - The CAPM (Capital Asset Pricing Model) says that the relevant risk of an individual asset is its contribution to the risk of a well-diversified portfolio (its portfolio or market risk). How the addition of a stock to the portfolio alters its Beta. The rest is diversified away.

What does it mean to say "the market is in equilibrium"?

required returns = expected returns

Beta

the tendency of a stock to move with the market is measured by it's _______ i.e. it measures market risk of a security / portfolio