Risk and Return in Capital Markets Flashcards
(14 cards)
What is meant by the return of an asset?
It is the gain or loss on an investment over a period, typically expressed as a percentage of the investment’s initial cost.
How is expected return calculated?
Expected Return = Weighted average of possible returns, with weights based on probabilities:
E(R)=∑pi×Ri
What does variance measure in finance?
Variance measures the expected squared deviation of returns from the mean; it represents the dispersion or spread of possible returns.
What is standard deviation (SD) and how is it related to variance?
Standard deviation is the square root of variance and represents volatility; it is in the same unit as returns.
Var(R)=0.045,SD(R)=
sqrt(0.045) =21.2%
What is the difference between realized and expected returns?
Realized Return: The actual return earned over a period.
Expected Return: The average return expected based on probabilities.
How do you compute a single period realized return?
Rt+1=(Div_(t+1)+(P_(t+1)-Pt))/Pt
DividendYield+CapitalGainRate
What is the Holding Period Return (HPR)?
HPR=(1+R 2005)×(1+R 2006)×⋯×(1+R 2009)−1
For example: HPR (2005–2009) = 2.13%
What is the normal distribution used for in finance?
To predict return outcomes with confidence intervals:
68.2% within ±1 SD
95.0% within ±2 SD
99.7% within ±3 SD
How do you compute a 95% confidence interval for returns?
CI= R ±2×SD(R)
Example: 3.1% ± 2×24.1% = -45.1% to 51.3%
What is the relationship between risk and return for individual stocks?
No clear relationship; smaller stocks may have higher volatility than larger stocks, but individual stock risk doesn’t guarantee higher returns compared to diversified portfolios.
What is the difference between common (systematic) and independent (unsystematic) risk?
common risk: affects all securities, cannot be diversified in any way (e.g. economic slowdown, interest rate change)
Independent risk: affects specific firms only, can be eliminated via diversification (e.g. CEO retirement, product recall)
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Which risks affect the required risk premium?
Only systematic (common) risks affect the required risk premium because these cannot be diversified away.
Identify whether the following are systematic or unsystematic risks:
a) CEO retires – Unsystematic
b) Oil prices rise – Systematic
c) Product recall – Unsystematic
d) Economic slowdown – Systematic
What are alternative names for unsystematic and systematic risks?
Unsystematic Risk: Firm-specific, idiosyncratic, unique, diversifiable risk
Systematic Risk: Market risk, undiversifiable risk
