Topic 7: Capital Markets and the Pricing of Risk

Question 1

What are Probability Distributions?

Answer 1

The probability distribution assigns a probability pR that each possible return R will occur.

Question 2

What is Expected Return?

Answer 2

Weighted average of the possible returns, with weights equal to the probabilities

Question 3

Expected Return Formula?

Answer 3

Question 4

Variance and Standard Deviation

Answer 4

Question 5

What is Realised Return?

Answer 5

Actual return over a particular time period

Question 6

Realised Return Formula

Answer 6

Question 7

Realised annual return for a stock where dividends are paid at the end of each quater

Answer 7

Question 8

Average Annual Return Formula

and

Variance Estimate Using Realised Returns

Answer 8

Question 9

How can we use past returns to predict the future?

Answer 9

• We can use a security’s historical average return to estimate its actual expected
• The average return is just an estimate of the expected return -> estimation error

Question 10

What is Standard Error?

Answer 10

Statistical measure of the degree of estimation error

Question 11

Statistical tests for Standard Error

Answer 11

Question 12

What is Excess Returns?

Answer 12

Difference between the average return for an investment and the average return for T-Bills

Question 13

What is common Risk?

Answer 13

• Risk that affects all securities
• Due to market-wide news
• Also known as Systematic Risk, Undiversifiable Risk or Market Risk

Question 14

What is Independent Risks?

Answer 14

• Risk that affects a particular security
• Due to firm specific news
• Also known as Firm-Specific Risk, Idiosyncratic Risk, Unique Risk, Unsystematic Risk or Diversifiable Risk

Question 15

What is Diversification?

Answer 15

The averaging out of independent risks in a large portfolio

Question 16

Explain the risk when many stocks are combined in a large portfolio

Answer 16

• The firm-specific risks for each stock will average out and be diversified
• The systematic risk will affect all firms and will not be diversified
• Only the unsystematic risk will be diversified when many firms stocks are combined into a portfolio
• The volatility will therefore decline until only the systematic risk remains

Question 17

What is the principle of the risk premium?

Answer 17

The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk

Question 18

What happens if the diversifiable risk of stocks were compensated with an additional risk premium?

Answer 18

• Then investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk
• By doing so, investors could earn an additional premium without taking on additional risk. This opportunity to earn something for nothing would quickly be exploited and eliminated
• Because investors can eliminate the firm-specific risk ‘for free’ by diversifying their portfolios, they will not require or earn a reward or risk premium for holding it

Question 19

What is the risk premium of a security determined by?

Answer 19

Its systematic risk and does not depend on its diversifiable risk

Question 20

What is a stock’s volatility?

Answer 20

• The measure of total risk: systematic + diversifiable risk
• Is not useful in determining the risk premium that investors will earn

Question 21

How do you measure the systematic risk of a stock?

Answer 21

Determine how much of the variability of its return is due to systematic risk versus unsystematic risk

Question 22

How do you determine how sensitive a stock is to systematic risk?

Answer 22

Look at the average change in the return for each 1% change in the return of a portfolio that fluctuates solely due to systematic risk

Question 23

What is an efficient portfolio?

Answer 23

A portfolio that contains only systematic risk. There is no way to reduce the volatility of this portfolio without lowering its expected return

Question 24

What is a Market Portfolio?

Answer 24

An efficient portfolio that contains all shares and securities in the market

Question 25

What is the Sensitivity to systematic Risk: Beta β

Answer 25

Expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio

Question 26

What is the difference between Beta and volatility?

Answer 26

- Volatility measures measures total risk - Beta is measure of only systematic risk. A security's beta is related to how sensitive its underlying revenues and cash flows are to general economic conditions

Question 27

What is the sensitivity of risk of stocks in cyclical industries?

Answer 27

Likely to be more sensitive to systematic risk and have higher betas than stocks in less sensitive industries

Question 28

Beta formula

Answer 28