Session 6

Question 1

State an important assumption when calculating historical returns

Answer 1

All dividends are immediately reinvested and used to purchase additional shares of the same stock or security.

Question 2

What is the formula for determining historical annual returns, based on quarterly data?

Answer 2

(1+R[q1]) * (1+R[q2]) * (1+R[q3]) * (1+R[q4])

Question 3

What is typically used as an estimate for Expected Return?

Answer 3

Average Annual Return

Question 4

What is typically used as an estimate for Expected Variance of Return?

Answer 4

Historical Variance

Question 5

Volatility seems to be a reasonable measure of risk for portfolios of stocks. Does this apply to individual stocks?

Answer 5

No

Question 6

Two types of news can affect the future cash-flows of a company - which are these?

Answer 6

Firm-Specific News

Market-Wide News

Question 7

What does idiosyncratic risk arise from?

Answer 7

Firm-specific factors

Question 8

What does systematic risk arise from?

Answer 8

Market-wide news

Question 9

What is another name for idiosyncratic risk?

Answer 9

Firm-specific / diversifiable risk

Question 10

What is another name for systematic risk?

Answer 10

Undiversifiable / market risk

Question 11

Define diversification

Answer 11

The process of combining many stocks into a large portfolio

Question 12

What is the result of diversification?

Answer 12

Firm-specific risks for each stock will average out and overall volatility will be reduced.

Question 13

Define risk premium

Answer 13

Compensation for holding a risky asset (e.g. a high-tech stock) instead of a risk-free asset

Question 14

How does Expected Return relate to Risk premium?

Answer 14

Expected Return = Risk-free Return + Risk Premium

Question 15

What is the risk premium for diversifiable risk?

Answer 15

Zero

Question 16

Why is a stock’s volatility not especially useful in determining the risk premium that investors will earn?

Answer 16

Because volatility measures total risk, and risk premium is based on systemic (non-diversifiable) risk.

Question 17

What is an efficient portfolio?

Answer 17

A portfolio that contains only systematic risk

Question 18

What is beta (β)?

Answer 18

The expected percent change in the return of a security for a 1% change in the return of the market portfolio

Question 19

How is beta different from volatility?

Answer 19

Volatility measures total risk (systematic plus idiosyncratic risk), while Beta is a measure of only systematic risk

Question 20

Which stocks are more likely to have high systemic risk?

Answer 20

Stocks in cyclical industries (computers, high- tech, office equipment, luxury goods) are likely to be more sensitive to systematic risk and have higher betas than stocks in less cyclical industries

Question 21

A security’s beta is related to how sensitive its…

Answer 21

…underlying revenues and cash flows are to general economic conditions

Question 22

State two definitions of the Market Risk Premium

Answer 22

The market risk premium is the reward investors expect to earn for holding a portfolio with a Beta of 1

It is the risk premium for a very well-diversified portfolio that only contains systematic risk

Question 23

State the formula for the Market Risk Premium

Answer 23

E [R(Mkt)] − r(f)

Question 24

State the CAPM formula for the expected return of a traded security

Answer 24

E [R]
= Risk-Free Interest Rate + Risk Premium
= r(f) + β × (E [R(mkt)] − r(f) )