Week 7

Question 1

Total return on stock depends on…

Answer 1

• Dividends

- Capital Gains (increase in share price)

Question 2

Formula for Total Return

Answer 2

Total Return = Dividends / Share Price at Year 1 + Capital Gain (end – start / start)

Question 3

Formula for Total Dollar Return

Answer 3

Total Dollar Return = Dividend Income + Capital Gain/Loss

Question 4

What does individual security variance (standard deviation) measure?

Answer 4

Individual security variance (or standard deviation) can be appropriate risk measure of a security only of an investor’s portfolio consists of just one security

Question 5

What are the four rules of portfolio return and risk?

Answer 5

• Rule 1: mean or expected return for an asset is the probability weighted average returns from all scenarios
• Rule 2: variance of an asset’s return is the expected value of the squared deviations from the expected return
• Rule 3: rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights
• Rule 4: When a risky asset is combined with a risk-free asset, the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the risky asset’s weighting
• Rule 5: when two risky assets with variances σ1² and σ2² are combined into a portfolio with portfolio weights w1 and w2, the portfolio variance is given by the formula

Question 6

What are the two difficulties to use past returns to predict the future expected returns?

Answer 6

• Do not know what investors expected in the past, can only observe the actual returns that were realized
• Average return is just an estimate of the true expected return

Question 7

Formula for Standard Deviation

Answer 7

SD (average of independent, identical risks) = SD (individual risk) / √Number of observations

Question 8

r=1 is a ______ correlation

Answer 8

positive

Question 9

r=-1 is a ______ correlation

Answer 9

negative

Question 10

Mean or expected return for an asset is the _____________ from all scenarios

Answer 10

Mean or expected return for an asset is the probability weighted average returns from all scenarios

Question 11

Variance of an asset’s return is the _____________ from the expected return

Answer 11

Variance of an asset’s return is the expected value of the squared deviations from the expected return

Question 12

Rate of return on a portfolio is a _____________ of each asset comprising the portfolio, with the portfolio proportions as _____

Answer 12

Rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights

Question 13

When a risky asset is combined with a _________, the portfolio standard deviation equals the ___________ multiplied by the _______________

Answer 13

When a risky asset is combined with a risk-free asset, the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the risky asset’s weighting

Question 14

Portfolio risk depends on how _______ the pairs of assets in the portfolio are

Answer 14

correlated

Question 15

Positive covariance _____ portfolio variance

Answer 15

increases

Question 16

Negative covariances ______ portfolio variance

Answer 16

reduces

Question 17

Why are there benefits to diversification?

Answer 17

• Benefits to diversification arise because stocks are not perfectly correlated
• When one asset does well or badly, its performance is not amplified by the performance of the other asset

Question 18

Stocks from different industries typically display _____ correlation than stocks from the same industry

Answer 18

lower

Question 19

If you mix stocks from different industries, portfolio risk is?

Answer 19

Portfolio risk is reduced

- stocks from different industries typically display lower correlation than stocks from the same industry

Question 20

What does adding foreign stocks lead to.

Answer 20

Adding foreign stocks leads to additional variance reduction
- Stocks in different countries move together even less because countries tend to be at different stages of the business cycle
Variance of an internationally diversified portfolio is less than 50% of the variance of a domestic portfolio with an equal number of stocks