Equity Risk & Return

Question 1

common stock

Answer 1

ownership
company management

Question 2

ownership

Answer 2

common stockholders represent an ownership interest in the business

Question 3

company management

Answer 3

the Company’s C-suite wants to increase common share price, as that is largely what drives their bonus

as a result, companies prioritize taking actions which will increase common stock price, and thus returns for shareholders

Question 4

sources of return in equity

Answer 4

dividends
price appreciation

Question 5

dividends

Answer 5

optional quarterly cash payments, made from the company to the shareholders

Question 6

price appreciation

Answer 6

increases in stock price

Question 7

S&P 500 returns

Answer 7

the S&P 500 is an index comprised of 500 large companies listed on stock exchanges in the united states

Question 8

sources of risk in equity

Answer 8

price declines

Question 9

price declines

Answer 9

a decline in the share price over the holding period would reduce aggregate returns

Question 10

equity has

Answer 10

variable returns *unlike every other security

Question 11

equity returns are driven by

Answer 11

quarterly dividends and stock price movements

Question 12

equity analysis

Answer 12

as a result, equity analysis is largely focused on estimating the return from investing in a stock

inversely, fixed income analysis is based almost entirely on estimating the required return

Question 13

expected return can be calculated two ways:

Answer 13

by taking a weighted average of the possible outcomes
by looking at the simple average of returns (not geometric average, simple average)

Question 14

individual security volatility

Answer 14

the most widely accepted measure of volatility is a security’s standard deviation. this is meant to measure how much the price, or return generated, from a security moves from year to year

Question 15

sharpe ratio

Answer 15

sharpe ratio is used to measure risk adjusted return
= (expected return- risk free rate)/ standard deviation

Question 16

two security portfolio- one risky, one free

Answer 16

expected return: the weighted average of the expected returns of the two securities
standard deviation: the standard deviation of the risky asset, times the weight of the risky asset

Question 17

covariance

Answer 17

measures the extent at which two variables (in this instance returns on two securities) move together
please note: if you only have a sample of available data the numerator is N-1, unless specified, assume that we are using the population formula noted below

Question 18

correlation

Answer 18

a number between -1 and 1, which in general notates how two securities move in relation to one another

covariance/ standard deviation x y

Question 19

perfect positive correlation

Answer 19

correlation +1, which means that the two security will move nearly in lockstep

Question 20

perfect negative correlation

Answer 20

a correlation of -1 which means that when one rises in value the other one falls in value

Question 21

efficient frontier

Answer 21

you want portfolio with lowest standard deviation- investing in low correlated or negatively correlated securities

Question 22

diversification

Answer 22

as can be seen on the prior slides, investing in stocks which have low correlation of returns results in lower volatility (meaning lower risk) without lower returns

this is known as the positive impact of diversification

Question 23

the positive impact of diversification

Answer 23

this impact of diversification is the key tenet of modern portfolio theory, which is used when investing for retirement

the lower the correlation of the returns of assets in a portfolio, the lower the volatility (aka risk) of that portfolio

Question 24

types of risk in investing

Answer 24

market risk
idiosyncratic risk

Question 25

market risk

Answer 25

the risk that an investment loses value as a result of a market wide movement

-equity investors are compensated for taking market risk, as they cannot effectively reduce this risk through diversification

Question 26

idiosyncratic risk

Answer 26

the risk that an investment loses value as a result of company specific issues (example: earnings release are below expectation )

Question 27

the market portfolio

Answer 27

the aggregate of all investors’ risky portfolios
-as a result, this includes every share of every outstanding stock at its current market price

Question 28

the market portfolio risk premium

Answer 28

the difference between the expected return on the market portfolio and the risk free rate

Question 29

a company’s Beta

Answer 29

a measure of how exposed that company is to systemic risk

it is a measure of correlation between the individual stock price movements and aggregate market movements