Risk and Return 2

Question 1

What is the purpose of probability analysis

Answer 1

The purpose of probability analysis is to enhance decision-making by evaluating not just the potential outcomes, but also likelihood of those outcomes occuring

Question 2

What does probability analysis do that sensitivity analysis doesn’t

Answer 2

Unlike sensitivity analysis - it quantifies risk and enables objective comparison across projects

Question 3

What are the key concepts of probability analysis

Answer 3

Key concepts of probability analysis are:
- Expected Return (Er)
- Standard Deviation (σA)

Question 4

What is expected return

Answer 4

Expected return is a weighted average of potential returns, each multiplied by the probability of occurrence

Question 5

ErA =

Answer 5

ErA = ∑(p ⋅ Ra)

Question 6

What is standard deviation

Answer 6

Standard deviation is a measure of risk or variability in returns

Question 7

What does a project having a higher standard deviation mean

Answer 7

Projects with higher standard deviation are riskier

Question 8

σA =

Answer 8

σA = √∑p(ra - Era)↑2

Question 9

What are the strengths of probability analysis

Answer 9

Strengths of probability analysis are: Incorporates both extent and likelihood of risk; supports rational comparisons

Question 10

What are the weaknesses of probability analysis

Answer 10

The weaknesses of probability analysis are: Relies on normal distribution; requires subjective probability estimates

Question 11

What type of risks do investors provide

Answer 11

Investors prefer lower risk for a given level of return

Question 12

How should company directors act

Answer 12

Company directors should act on behalf of shareholders’ risk appetite, not their own

Question 13

CoV =

Answer 13

CoV = σ/Er

Question 14

What does the CoV standardise the risk of

Answer 14

CoV standardizes risk per unit of return

Question 15

When is CoV useful

Answer 15

CoV is useful when comparing projects with different expected returns

Question 16

How is lower CoV preferable for

Answer 16

Lower CoV = preferable for risk-averse decision makers

Question 17

Who may higher CoV appeal to

Answer 17

Higher CoV = may appeal to risk-tolerant stakeholders

Question 18

Who developed modern portfolio theory (MPT)

Answer 18

MPT was developed by Harry Markowitz (1952)

Question 19

What are the core principles of MPT

Answer 19

MPT core principles: Investors are rational and make decisions using mean-variance analysis

Question 20

Expected return of a portfolio =

Answer 20

Expected return of a portfolio = weighted average of returns

Question 21

Risk of a portfolio <

Answer 21

Risk of a portfolio < weighted average of individual risks

Question 22

What does correlation coefficient (p) determine

Answer 22

Correlation Coefficient (p): Determines how much diversification reduces risk

Question 23

p = +1 -

Answer 23

p = +1 - no risk reduction

Question 24

p = -1 -

Answer 24

p = -1 - maximum risk reduction

Question 25

What does forming a portfolio with low or negative correlation between assets significantly reduce

Answer 25

Forming a portfolio with low or negative correlation between assets significantly reduces risk

Question 26

Who can diversify more easily investors or corporations

Answer 26

Investors can diversify more easily and cheaply than corporations

Question 27

Why is corporate diversification rare

Answer 27

Corporate diversification is rare due to management capability limits

Question 28

What is unsystematic risk

Answer 28

Unsystematic risk is firm specific

Question 29

Is unsystematic risk diversifiable

Answer 29

Unsystematic risk is diversifiable

Question 30

What is systematic risk

Answer 30

Systematic risk is market wide

Question 31

Is systematic risk diversifiable

Answer 31

Systematic risk is not diversifiable

Question 32

Who developed Capital Asset Pricing Model (CAPM)

Answer 32

CAPM was developed by Sharpe (1964)

Question 33

What is the purpose of CAPM

Answer 33

CAPM links systematic risk with expected return using the beta coefficient

Question 34

CAPM equation ErL =

Answer 34

ErL = Ef + [)ErM - Rf) ⋅ βl] Where: - ErL: Expected return of asset - Rf: Risk-free rate - ErM: Expected market return - βl: Beta of asset L, measures sensitivity to market

Question 35

What are the strengths of CAPM

Answer 35

Strengths of CAPM are: Simple, intuitive, used widely in valuation

Question 36

What are the weaknesses of CAPM

Answer 36

The weaknesses of CAPM are: Unrealistic assumptions, historic data used for future predictions