chapter 10

Question 1

probability distribution

Answer 1

summarises the information regarding risky investments and the different returns they may earn and their likelihood of occuring. it assigns a probability pR, that each possible return, R, will occur.

Question 2

return of a security

Answer 2

indicates the percentage increase in the value of an investment per dollar initially invested in the security. it makes different securities comparable.

Question 3

expected return

Answer 3

a weighted average of the possible returns, where the weights correspond to the probabilities.

Question 4

volatility

Answer 4

the standard deviation of a return in finance terms.

Question 5

variance

Answer 5

the expected squared deviation from the mean.

Question 6

standard deviation

Answer 6

the square root of the variance. it quantifies the difference in variability.

Question 7

realised return

Answer 7

the return that actually occurs over a particular time period of all the possible returns.

Question 8

average annual return

Answer 8

the average of the realised returns for each year during some historical period.

Question 9

standard error

Answer 9

the estimation of error of a statistical estimate. it is the standard deviation of the estimated value of the mean of the actual distribution around its true value. so, it is the standard deviation of the average return.

Question 10

95% confidence interval

Answer 10

a reasonable range of the true expected value. it means that the average return will be within two standard errors of the true expected return approximately 95% of the time.

Question 11

excess return

Answer 11

the difference between the average return for the investment and the average return for Treasury bills, which are a risk-free investment and measure the average risk premium investors earned for bearing the risk of the investment.

Question 12

independent/firm-specific/idiosyncratic/unique/diversifiable risk

Answer 12

risk that is perfectly correlated. it causes fluctuations in a stock’s return due to firm-specific news. it is averaged out and diversified when many stocks are combined in a large portfolio.

Question 13

common/systematic/undiversifiable/market risk

Answer 13

risks that share no correlation. it causes fluctuations in a stock’s return due to market-wide news. it affects all firms and therefore the entire portfolio and cannot be diversified.

Question 14

firm-specific news

Answer 14

good or bad news about the company itself.

Question 15

market-wide news

Answer 15

news about the economy as a whole and therefore it affects all stocks.

Question 16

risk premium

Answer 16

the difference between the market portfolio’s expected return and the risk-free interest rate. it is determined by the security’s systematic risk.

Question 17

efficient portfolio

Answer 17

a portfolio that contains only systematic risk. changes in the price of the portfolio will reflect systematic shocks to the economy. it cannot be diversified further, meaning risk cannot be reduced without lowering expected return. an efficient portfolio should be a large portfolio containing many different stocks, because diversification improves with the number of stocks.

Question 18

market portfolio

Answer 18

a portfolio of all stocks and securities traded in the capital market. it is a natural candidate for an efficient portfolio.

Question 19

beta

Answer 19

the sensitivity of the security’s return to the return of the market portfolio/market-wide risk factors. it is the expected % change in return given a 1% change in the return of the market portfolio. it is related to how sensitive its underlying revenues and cash flows are due to general economic conditions.

Question 20

market risk premium

Answer 20

the reward investors expect to earn for holding a portfolio with a beta of one, the market portfolio.

Question 21

Capital Asset Pricing Model (CAPM)

Answer 21

a method for estimating the cost of capital.

Question 22

diversification

Answer 22

the averaging out of independent risks in a large portfolio.