Chapter 7

Question 1

What is risk in the context of finance?

Answer 1

Risk refers to the uncertainty regarding the return on an investment.

Question 2

True or False: All investments carry the same level of risk.

Answer 2

False.

Question 3

What does return refer to in finance?

Answer 3

Return refers to the gain or loss made on an investment.

Question 4

Fill in the blank: The higher the risk, the ______ the potential return.

Answer 4

higher

Question 5

What is the risk-return tradeoff?

Answer 5

It is the principle that potential return rises with an increase in risk.

Question 6

Define systematic risk.

Answer 6

Systematic risk is the risk inherent to the entire market or market segment.

Question 7

Define unsystematic risk.

Answer 7

Unsystematic risk is the risk specific to a company or industry.

Question 8

What is the Capital Asset Pricing Model (CAPM)?

Answer 8

CAPM is a model that describes the relationship between systematic risk and expected return.

Question 9

True or False: CAPM assumes that investors are risk-averse.

Answer 9

True.

Question 10

What does beta measure?

Answer 10

Beta measures the sensitivity of an asset’s returns to the returns of the market.

Question 11

What is a risk-free rate?

Answer 11

The risk-free rate is the return on an investment with zero risk, typically represented by government bonds.

Question 12

Fill in the blank: The expected return on an asset is equal to the risk-free rate plus the _______.

Answer 12

risk premium

Question 13

What is a risk premium?

Answer 13

The risk premium is the additional return expected for taking on additional risk.

Question 14

What does the efficient market hypothesis (EMH) state?

Answer 14

EMH states that asset prices fully reflect all available information.

Question 15

True or False: Under EMH, it is possible to consistently achieve higher returns than the market average.

Answer 15

False.

Question 16

What is diversification?

Answer 16

Diversification is the practice of spreading investments across various assets to reduce risk.

Question 17

What is the purpose of the risk-return analysis?

Answer 17

To evaluate the tradeoff between the expected return and the risk of an investment.

Question 18

What does standard deviation measure in finance?

Answer 18

Standard deviation measures the dispersion of returns around the mean return.

Question 19

Fill in the blank: A higher standard deviation indicates ______ risk.

Answer 19

higher

Question 20

What is the Sharpe ratio?

Answer 20

The Sharpe ratio is a measure of risk-adjusted return.

Question 21

What does a higher Sharpe ratio indicate?

Answer 21

A higher Sharpe ratio indicates better risk-adjusted performance.

Question 22

What is the purpose of the security market line (SML)?

Answer 22

The SML represents the expected return of an asset as a function of its systematic risk.

Question 23

What does the slope of the SML represent?

Answer 23

The slope of the SML represents the market risk premium.

Question 24

True or False: A stock with a beta of 1 is expected to move in line with the market.

Answer 24

True.

Question 25

What is the difference between nominal return and real return?

Answer 25

Nominal return does not account for inflation, while real return does.

Question 26

Fill in the blank: The _______ return is adjusted for inflation.

Answer 26

real

Question 27

What is the formula for calculating expected return using CAPM?

Answer 27

Expected return = Risk-free rate + Beta * (Market return - Risk-free rate)

Question 28

What is a portfolio?

Answer 28

A portfolio is a collection of financial assets such as stocks, bonds, and cash.

Question 29

What is the primary goal of portfolio management?

Answer 29

To maximize returns while minimizing risk.

Question 30

True or False: Correlation between assets can affect the overall risk of a portfolio.

Answer 30

True.

Question 31

What does a correlation coefficient of 1 indicate?

Answer 31

A perfect positive correlation between two assets.

Question 32

What does a correlation coefficient of -1 indicate?

Answer 32

A perfect negative correlation between two assets.

Question 33

Fill in the blank: A well-diversified portfolio should include assets with ______ correlation.

Answer 33

low

Question 34

What is the main advantage of using options in risk management?

Answer 34

Options can be used to hedge against potential losses.

Question 35

What is a derivative?

Answer 35

A derivative is a financial instrument whose value is derived from the value of an underlying asset.

Question 36

What is the primary purpose of hedging?

Answer 36

To reduce the risk of adverse price movements in an asset.

Question 37

True or False: Hedging can completely eliminate risk.

Answer 37

False.

Question 38

What is the concept of arbitrage?

Answer 38

Arbitrage is the practice of taking advantage of price differences in different markets.

Question 39

What does the term 'leverage' refer to in finance?

Answer 39

Leverage refers to the use of borrowed capital to increase the potential return of an investment.

Question 40

Fill in the blank: Increased leverage also increases ______ risk.

Answer 40

financial

Question 41

What is meant by the term 'market risk'?

Answer 41

Market risk is the risk of losses in investments due to market fluctuations.

Question 42

What is a risk-adjusted return?

Answer 42

A return that has been adjusted for the level of risk taken to achieve it.

Question 43

True or False: All investors have the same risk tolerance.

Answer 43

False.

Question 44

What is behavioral finance?

Answer 44

Behavioral finance studies the psychological influences on investors' decisions.