Ch.6

Explain what is meant by country risk.

Country risk is the same thing as political risk. It refers to the political and economic stability and viability of a country's economy. The United States can be used as a benchmark with which to judge other countries on a relative basis.

Distinguish between historical return and expected return

Historical returns are realized returns, such as those reported by Ibbotson Associates. Expected returns are returns expected to occur in the future. They are the most likely returns for the future, although they may not actually be realized because of risk.

Classify the traditional sources of risk as to wheather they are general sources of risk or specific sources of risk

Systematic risk: market risk, interest rate risk, inflation risk, exchange rate risk, and country risk. Nonsystematic risk: business risk, financial risk, and liquidity risk.

Can any of these components be negative?

While either component can be zero for a given security over a specified time period, only the capital change component can be negative.

How long must an asset be held to calculate a return?

A Total Return can be calculated for any asset for any holding period. Both monthly and annual TRs are often calculated, but any desired period of time can be used.

What is an equity risk premium?

An equity risk premium is the difference between stocks and a risk-free rate (proxied by the return on Treasury bills). It represents the additional compensation, on average, for taking the risk of equities rather than buying Treasury bills.

According to Table 6-6 common stocks have generally returned more bond. How then can they be considered more risky?

As Table 6-6 shows, the risk (standard deviation) of large common stocks was about two and one-half times that of government and corporate bonds. Therefore, common stocks are clearly more risky than bonds, as they should be since larger returns would be expected to be accompanied by larger risks over long periods of time.

How is interest rate risk related to inflation risk

Business risk is the risk of doing business in a particular industry or environment. Interest rate risk and inflation risk are clearly directed related. Interest rates and inflation generally rise and fall together.

How would you evaluate the country risk of Canada and Mexico?

Canada would be considered to have relatively low country risk. Mexico seems to be on the upswing economically, but certainly has its risk in the form of nationalized industries, overpopulation, drug cartels and other issues. Mexico has also experienced a dramatic devaluation of the peso in the past.

Distinguish between market risk and business risk.

Market risk is the variability in returns due to fluctuations in the overall market. It includes a wide range of factors exogenous to securities themselves.

Defines risk. How does use of the standard deviation as a measure of risk related to this definition of risk?

Risk is the chance that the actual outcome from an investment will differ from the expected outcome. Risk is often associated with the dispersion in the likely outcomes. Dispersion refers to variability, and the standard deviation is a statistical measure of variability or dispersion. Standardization measures risk in an absolute sense.

What is the mathematical linkage between the arithmetic mean and the geometric mean for a set a security stock return?

See Equation 6-11. Knowing the arithmetic mean and the standard deviation for a series, the geometric mean can be approximated.

Distinguish between return and holding periode return

TR, another name for holding period return, is a decimal or percentage return, such as +.10 or -15%. The term "holding period return" is sometimes used instead of TR. Return relative adds 1.0 to the TR in order that all returns can be stated on the basis of 1.0 (which represents no gain or loss), thereby avoiding negative numbers so that the geometric mean can be calculated.

When should the arithmetic mean be used in describing stock return?

The arithmetic mean should be used when describing the average rate of return without considering compounding. It is the best estimate of the rate of return for a single period. Thus, in estimating the rate of return for common stocks for next year, we use the arithmetic mean and not the geometric mean. The reason is that because of variability in the returns, we will have to earn, on average, the arithmetic rate in order to achieve a compound rate of growth which is given by the smaller geometric mean.

When should the geometric mean return be used to measure return?

The geometric mean is a better measure of the change in wealth over more than a single period. Over multiple periods the geometric mean indicates the compound rate of return, or the rate at which an invested dollar grows, and takes into account the variability in the returns.

Why will it always be less than the arithmetic mean?

The geometric mean is always less than the arithmetic mean because it allows for the compounding effect--the earning of interest on interest.

Assume that you purchase a yen-denominated stock on a Japanese Market. During the periode you hold the stock, the yen weakens relative to the dollar. How will your conversion of yen to dollars affect your return?

The return on the Japanese investment is now worth less in dollars. Therefore, the investor's return will be less after the currency adjustment. EXAMPLE: Assume an American investor in the Japanese market has a 30% gain in one year but the Yen declines in value relative to the dollar by 10%. The percentage of the original investment after the currency risk is accounted for is (0.9)(130%) = 117%. Therefore, the investor's return is 17%, not 30%. In effect, the investor loses 10% on the original wealth plus another 10% on the 30% gain, or a total of 13 percentage points of the before-currency-adjustment return of 130% of investment.

Defines the components of return?

Total return for any security consists of an income (yield) component and a capital gain (or loss) component. • The yield component relates dividend or interest payments to the price of the security. • The capital gain (loss) component measures the gain or loss in price since the security was purchased.