Risk and Return

13. Your spouse works for Southwest Airlines and you work for a grocery store. Is your company or your spouse's company likely to be more exposed to systematic risk?

Southwest Airlines is more exposed to systematic risk. Systematic risk describes the movement of the stock relative to the market. Grocery stores will perform about the same in a recession and a boom, as consumers do not alter their purchases of groceries much. But air travel is more sensitive to market swings, so an airline will be exposed to more systematic risk.

9. What is the difference between systematic and unsystematic risk?

Systematic risk is the risk that cannot be diversified away, while unsystematic risk is the risk that is diversifiable

12. Why doesn't the risk premium of a stock depend on its diversifiable risk?

The diversifiable risk is the risk that investors can eliminate by combining stocks into a portfolio. Because investors can eliminate this risk on their own, investors are not compensated for holding onto diversifiable risk. Only systematic risk is priced.

If you randomly select 10 stocks for a portfolio and 20 other stocks for a different portfolio, which portfolio is likely to have the lower standard deviation? Why?

The portfolio with 20 randomly selected stocks likely will have a lower standard deviation of returns than the portfolio with 10 randomly selected stocks. The additional 10 stocks should decrease the standard deviation of returns by increasing the diversification of unsystematic risk.

1. What does the historical relation between volatility and return tell us about investors' attitude toward risk?

1. The historical relation between volatility and return tells us that investors are risk averse.

2. What are the components of a stock's realized return?

2. The components of a stock's realized return are dividend yield and capital gain.

3. What is the intuition behind using the average annual return as a measure of expected return?

3. If we believe that the distribution of possible returns for a stock does not change over time, then the historical average return is a good estimate of what to expect in the future.

7. What is meant by diversification and how does it relate to common versus independent risk?

Diversification is the elimination of risk by combining multiple assets into a portfolio. The risk that is eliminated through diversification is the independent risk. This is the risk that is unique to a particular stock. The common risk, or risk that is shared by all stocks, cannot be diversified away.

4. How does standard deviation relate to the general concept of risk?

The risk of an investment is the potential for an investment's return to be different than expected. Standard deviation of returns is the measure of how volatile returns have been over a period of time. Thus, standard deviation is a good measure for how much a stock's return may differ from its expected return.

6. Consider two local banks. Bank A has 100 loans outstanding, each for $1 million, that it expects will be repaid today. Each loan has a 5% probability of default, in which case the bank is not repaid anything. The chance of default is independent across all the loans. Bank B has only one loan of $100 million outstanding that it also expects will be repaid today. It also has a 5% probability of not being repaid. Explain the difference between the type of risk each bank faces. Assuming you are averse to risk, which bank would you prefer to own?

The two banks face the same probability of default on each individual loan, but in the case of Bank A, the risk of default is spread among 100 different loans. Thus, Bank A can diversify the risk of default among its 100 loans. Bank B has no diversification of its risk because there is only one loan. Thus, they face the same systematic risk, but Bank B faces higher unsystematic risk. If you are risk averse, you would prefer to own Bank A.

5. How does the relationship between the average return and the historical volatility of individual stocks differ from the relationship between the average return and the historical volatility of large, well‐ diversified, portfolios?

There is a strong relationship between the average returns and historical volatility of portfolios, but this relationship breaks down when looking at average returns and historical volatility of individual stocks.

8. Which of the following risks of a stock are likely to be unsystematic, diversifiable risks and which are likely to be systematic risks? Which risks will affect the risk premium that investors will demand? a. The risk that the founder and CEO retires. b. The risk that oil prices rise, increasing production costs. c. The risk that a product design is faulty and the product must be recalled. d. The risk that the economy slows, reducing demand for the firm's products. e. The risk that your best employees will be hired away. f. The risk that the new product you expect your R&D division to produce will not materialize.

a. Diversifiable risk b. Systematic risk c. Diversifiable risk d. Systematic risk e. Diversifiable risk f. Diversifiable risk

There are three companies working on a new approach to customer‐tracking software. You work for a software company that thinks this could be a good addition to its software line. If you invest in one of them versus all three of them: a. Is your systematic risk likely to be very different? b. Is your unsystematic risk likely to be very different?

a. The systematic risk of investing in one company is not likely to be different than the systematic risk of investing in all three. The systematic risk of developing the software will be roughly the same for each of the three firms. So, each company is as risky (in terms of systematic risk) as the others. The systematic risk of a portfolio is simply the weighted average of the systematic risk of each asset in the portfolio. Because each company has approximately the same systematic risk, the weighted average of the betas of each company will result in the same beta for the portfolio. b. The unsystematic risk of investing in just one company will be higher than investing in all three companies. The unsystematic risk of each company can be reduced in a portfolio by combining the companies together. Thus, the risk that one company will not succeed in the development of the new software is offset by the likely success of one of the other firms. Therefore, the unsystematic risk of the portfolio will be less than the unsystematic risk of each company by itself.