Chapter 13 Flashcards
(20 cards)
What is the expected return of an investment?
It is the probability-weighted average of possible returns.
Expected return is crucial for assessing investment performance.
How is variance defined in finance?
Variance is the probability-weighted average of squared deviations from the expected return.
Variance measures the dispersion of returns.
What does standard deviation represent?
It is the square root of variance, measuring the spread of returns around the mean.
Standard deviation is often used to assess risk.
What is a portfolio in finance?
A portfolio is a basket of different securities or assets.
Portfolios are used to manage risk and return.
How is the expected return of a portfolio calculated?
It is the weighted average of the expected returns of the individual assets.
This calculation considers the proportion of each asset in the portfolio.
Is the variance of a portfolio a weighted average of individual variances?
No, it depends on the correlations between asset returns.
Correlation affects the overall risk of the portfolio.
What does positive covariance indicate?
It indicates that two asset returns tend to move in the same direction.
Positive covariance can increase portfolio risk.
What does negative covariance indicate?
It indicates that two asset returns tend to move in opposite directions.
Negative covariance can help in risk reduction through diversification.
What is diversification?
Investing in assets with low correlation to reduce portfolio risk.
Diversification can lead to more stable returns.
What is systematic risk?
Market-wide risk that cannot be diversified away.
Systematic risk affects all investments.
What is unsystematic risk?
Asset-specific risk that can be diversified away.
This risk is unique to a particular asset or company.
What is beta in finance?
Beta measures an asset’s sensitivity to market movements.
A beta greater than 1 indicates higher volatility than the market.
What is the CAPM formula?
Expected return = Risk-free rate + Beta × (Market return - Risk-free rate).
CAPM is used to estimate the expected return on an asset.
What is the Security Market Line (SML)?
A graphical representation of the CAPM, showing expected return vs. beta.
The SML helps visualize the relationship between risk and return.
What is portfolio beta?
The weighted average of the betas of the individual assets in the portfolio.
Portfolio beta indicates the overall market risk of the portfolio.
What does the Arbitrage Pricing Theory (APT) suggest?
That returns can be predicted using multiple macroeconomic factors.
APT allows for a more flexible approach compared to CAPM.
What are the components of total risk?
Total risk = Market risk + Asset-specific risk.
Understanding these components is vital for risk management.
What happens when assets are perfectly negatively correlated?
Portfolio risk can be eliminated completely.
This scenario is ideal for risk management.
Why do investors diversify?
To reduce unsystematic risk and potentially achieve better risk-adjusted returns.
Diversification is a fundamental principle in investment strategy.
Why is the CAPM useful?
It helps determine the appropriate required rate of return for an asset.
CAPM is widely used in finance for asset pricing.
