Chapter 13 Return, risk, and the security market line

Question 1

reward for bearing risk

Answer 1

risk premium

Question 2

2 types of risk

Answer 2

1. systematic
2. unsystematic

Question 3

highly diversified portfolios will tend to have no unsystematic risk

Answer 3

principle of diversification

Question 4

the relationship between risk and return is shown

Answer 4

security market line (SML)

Question 5

scenarios with particular probabilites

Answer 5

states of the economy

Question 6

the return on a risky asset expected in the future

Answer 6

Expected return
(the expected return on a security is equal to the sum of the possible return multiplied by their responsibilities)

Question 7

the difference between the return on a risky investment and the return on a risk free investment

Answer 7

Risk premium

Question 8

How to determine the variance of returns on securities in 3 ways

Answer 8

1. Determine the squared deviations from the expected return
2. Multiply each possible squared deviation by its probability
3. Sum the products of step 2

Question 9

a group of assets such as stocks and bonds held by an investor

Answer 9

Portfolio

Question 10

the percentage of a portfolios total value that is invested in a particular asset

Answer 10

Portfolio weight
(The expected return on a portfolio is the weighted average of the expected return of the assets in the portfolio)

Question 11

The expected return on a portfolio is the weighted average of the expected return of the assets in the portfolio

Answer 11

substantially alter the risks faced by the investor

Question 12

Portfolios increase diversification, thereby _____ risk

Answer 12

decreasing

Question 13

The return on any stock traded in a financial market is composed of 2 parts

Answer 13

1. Expected return: predicted by the market
2. Unexpected return: comes from unexpected information revealed

Question 14

In the long run the average value of unexpected returns will be zero, so on average the actual return equals

Answer 14

the expected return

Question 15

a discounted announcement has less of an impact on the price because the market already knew much of it

Answer 15

Price in

Question 16

a difference between the actual result and the forecast

Answer 16

Innovation/Surprise

Question 17

Expected part of the anouncement formula is used by the market to form

Answer 17

expectations

Question 18

Surprise in the anouncement formula influences the

Answer 18

unexpected return

Question 19

a risk that influences a larger number of assets

Answer 19

Systematic risk/market risk
(Examples: GDP, interest rates, inflation)

Question 20

All firms are susceptible to this

Answer 20

systematic risk

Question 21

a risk that affects at most a small number of assets

Answer 21

Unsystematic risk/unique or asset specific risk
(Examples: pharmaceutical research breakthrough, oil strike)

Question 22

the process of spreading an investment across assets (and thereby forming a portfolio

Answer 22

Diversification

Question 23

spreading an investment across a number of assets will eliminate some, but not all, of the risk

Answer 23

Principle of diversification

Question 24

2 key points of principles of diversification

Answer 24

1. Some of the riskiness associated with individual assets can be eliminated by forming portfolios
2. There is a minimum level of risk that cannot be eliminated by diversifying (nondiversifiable risk)

Question 25

________ risk tends to wash out when assets are combine into portfolios, once there are more than just a few assets

Answer 25

unsystematic risk

Question 26

Unsystematic risk is essentially eliminated by

Answer 26

diversification (so a portfolio with many assets has almost no unsystematic risk)

Question 27

______ risk cannot be eliminated by diversification

Answer 27

systematic

Question 28

Also call non-diversifiable

Answer 28

systematic risk

Question 29

the expected return on a risky asset depends only on that assets systematic risk

Answer 29

Systematic risk principle

Question 30

No reward for bearing ________ risk because it can be eliminated at virtually no cost (by diversification)

Answer 30

unsystematic risk

Question 31

the amount of systematic risk present in a particular risky asset relative to that in an average asset

Answer 31

Beta coefficient

Question 32

An average asset has a beta of

Answer 32

1.0

Question 33

The beta of the market is

Answer 33

1.0

Question 34

Because assets with larger betas have greater systematic risks, they will have _______ expected returns

Answer 34

greater

Question 35

The reward to risk ratio must be

Answer 35

the same for all the assets in the market

Question 36

a positively sloped straight line displaying the relationship between expected return and beta

Answer 36

Security market line (SML)

Question 37

Describes the relationship between systematic risk and expected return in financial markets

Answer 37

Security market line (SML)

Question 38

the slop of the SML: which is the difference between the expected return on a market portfolio and the risk free rate

Answer 38

Market risk premium

Question 39

the equation of the SML showing the relationship between expected return and beta

Answer 39

Capital asset pricing model (CAPM)

Question 40

The CAPM shows that the expected return for a particular asset depends on 3 things

Answer 40

1. The pure time value of money: as measure by the risk free rate, Rꜜf this is the reward for merely waiting for your money, without taking any risk 2. The reward for bearing systematic risk: as measured by the market risk premium, E (Rꜜm) - Rꜜf , this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting 3. The amount of systematic risk: as measured by bet, βi, this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset

Question 41

the excess return as asset earns based on the level of risk taken

Answer 41

Alpha

Question 42

The distance between actual return and the SML

Answer 42

alpha

Question 43

an asset or portfolio has earned a return greater than what should have been earned based on its beta

Answer 43

Positive alpha

Question 44

an asset or portfolio has earned a return less than what should have been earned based on its beta

Answer 44

Negative alpha