Ch6 Risk and Return Flashcards
(16 cards)
What is the purpose of accounting for risk in investment decisions?
To ensure that investment evaluations reflect the uncertainty of outcomes and reward appropriate risk levels.
What distribution is often used to model stock returns and why?
Stock returns are often assumed to follow a normal distribution because it’s a reasonable empirical approximation, supported by the central limit theorem, and allows for analysis using just mean and variance.
What is the difference between price and return distributions?
Prices are assumed to follow a lognormal distribution, while returns are modeled with a normal distribution.
What are the first two moments of a distribution?
Expected value (mean) and variance (or standard deviation).
What does the correlation coefficient (ρ) measure?
The strength and direction of a linear relationship between two securities’ returns.
How does diversification affect portfolio risk?
Diversification reduces unsystematic (firm-specific) risk; only systematic risk remains.
What is the minimum variance portfolio (MVP)?
The portfolio with the lowest possible risk (variance) among all possible combinations of risky assets.
What is the efficient frontier?
A set of optimal portfolios offering the highest expected return for a defined level of risk.
What is the Capital Market Line (CML)?
The line representing portfolios that optimally combine the risk-free asset and the market portfolio.
What is beta in the CAPM?
A measure of a security’s sensitivity to market movements; the ratio of its covariance with the market to the market variance.
What is the CAPM formula?
Expected Return = Risk-free rate + Beta × Market Risk Premium.
What assumptions underlie the CAPM?
Investors are rational and risk-averse, markets are frictionless, all investors have homogenous expectations, and there is a risk-free rate.
What are the limitations of CAPM?
It relies on unrealistic assumptions, uses hard-to-estimate parameters, and performs poorly empirically.
What is the Fama-French Three-Factor Model?
An extension of CAPM that adds size (SMB) and value (HML) factors to explain stock returns.
What is the Carhart Four-Factor Model?
It extends the Fama-French model by adding a momentum factor (MOM) to capture return persistence.
Why does CAPM remain widely used?
Despite its flaws, it’s simple, requires fewer inputs, and performs adequately for most practical purposes.
