chapter 13

Unsystematic risk is also known as:

-Firm-specific risk -Idiosyncratic risk -Unique risk -Diversifiable risk -Asset-specific risk

What does alpha measure? What is a desired alpha level on investments?

Alpha measures the vertical distance of an asset's return from the SML. -> it measures the return in excess of the return the asset should have earned based on the level of risk as measured by beta. A positive alpha means that the return is HIGHER than it should have been given the level of risk taken; while a negative alpha means that the return was too low given the level of risk taken. POSITIVE ALPHA IS ALWAYS BETTER.

If beta = 0, the asset has __ _________ ______.

If beta = 0, the asset has no measurable systematic risk.

If beta < 1, the systematic risk for the asset is ____ than the average for assets in the market.

LESS

If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio?

NO!!!! The portfolio expected return is a weighted average of the assets returns. SO it must be less than the largest asset return and greater than the smallest asset return.

Systematic or unsystematic risk: Short-term interest rates increase unexpectedly

Systematic

What is the only type of risk that an efficient portfolio contains?

Systematic risk - there is no way to reduce the volatility of the portfolio without lowering the expected return of the portfolio.

What is the market risk premium?

The market risk premium is the reward investors expect to earn for holding a portfolio with a beat of 1.

In an efficient market what would we expect the alpha of all assets to equal?

zero

Beta = ______ __ ___________ __________ / _______ __ __________ ___________

Beta = Change in stock returns / change in market returns

Systematic or unsystematic risk: Oil prices unexpectedly decline

Both, mostly systematic

What are two benefits of diversification? Why do these benefits occur?

Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another. HOWEVER, there is a minimum level of risk that cannot be diversified away and that is the SYSTEMATIC PORTION.

Efficient markets are the result of investors trading on the _________ portion of announcements.

Efficient markets are the result of investors trading on the UNEXPECTED portion of announcements.

Capital Asset Pricing Model: _____ ______ = ____-____ ____ + ____ + _________ ____ _________

Expected return = risk-free rate + beta + market risk premium

True or false: The most important characteristic in determining the expected return of a well-diversified portfolio is the variance of the individual assets in the portfolio.

FALSE The variance of the individual assets is a measure of the total risk. The variance on a well-diversified portfolio is a function of systematic risk ONLY.

If beta > 1, the systematic risk for the asset is _______ than the average for assets in the market.

GREATER

What do covariance and correlation measure?

Measure how 2 random variables are related. The relationship between one stock's return and another stock's return.

What do variance and standard deviation measure?

Measure the variability of individual stocks.

Why are some risk diversifiable and others not?

Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at LITTLE cost. However, on the other hand, there are risks that affect ALL investments <- this portion of the total risk of an asset cannot be costlessly eliminated.

What is the difference between standard deviation and beta?

Standard deviation measures total risk (systematic + unsystematic) Beta only measures SYSTEMATIC risk.

Systematic or unsystematic risk: A Supreme Court decision substantially broadens producer liability for injuries suffered by product users

Systematic

What is systematic risk?

Systematic risk is due to market-wide news, it affects a large number of assets. It is also known as undiversifiable risk or market risk

What does beta measure?

The sensitivity to systematic risk. It is the expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio.

What component of an announcement affects a stock's price and therefore, its return?

The surprise component of an announcement is what affects a stock's price and therefore its return. Announcements and news contain expected and surprise parts.

Why is "keep your alpha high and your beta low" a common wall street phrase?

This is because keeping your beta low means you have a low level of systematic risk, while a high alpha means that your return is high compared to the level of risk taken.

Why is it that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

This is because some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at LITTLE cost. However, on the other hand, there are risks that affect ALL investments <- this portion of the total risk of an asset cannot be costlessly eliminated. AKA, systematic risk can be controlled, HOWEVER ONLY by a COSTLY reduction in expected returns

Total return = __________ _________ + _________ ___________

Total return = expected return + unexpected return

Total risk = ______ risk + _______ risk

Total risk = systematic risk + unsystematic risk

Unexpected return = __________ portion + __________ portion

Unexpected return = systematic portion + unsystematic protion

Systematic or unsystematic risk: A manufacturer loses a multimillion-dollar product liability suit

Unsystematic

Systematic or unsystematic risk: An oil tanker ruptures, creating a large oil spill

Unsystematic

Systematic or unsystematic risk: The interest rate a company pays on its short-term borrowing is increased by it bank

Unsystematic

Why is systematic risk the only risk that matters?

Well diversified portfolios ONLY contain systematic risk. Portfolios that are not well- diversified face systematic risk + unsystematic risk. No one will compensate investors for bearing unsystematic risk

Is it possible that a risky asset could have a beta of zero?

Yes, it is possible to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument.

If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?

Yes, the standard deviation can be less than that of every asset in the portfolio. However, beta CANNOT be less than the smallest beta because BETA IS A WEIGHTED AVERAGE of the individual asset betas.

Over time, what is the average of the unexpected return component of realized return?

Zero.