Week 6

Question 1

What are types of investments?

Answer 1

1. Standard & Poor’s 500: 90 U.S. stocks up to 1957 and 500 after that. Leaders in their industries and among the largest firms traded on U.S. Markets.
2. Small Stocks Portfolio: Securities traded on the NYSE with market capitalizations in
   the bottom 20%.
3. World Portfolio: International stocks from all the world’s major stock markets in North America, Europe, and Asia.
4. Corporate Bonds Portfolio: Long-term, AAA-rated U.S. corporate bonds with maturities of approximately 20 years.
5. Treasury Bills: An investment in three-month Treasury bills

Question 2

What is realized return?

Answer 2

The return that actually occurs over a particular time period.

Question 3

equation for realized return?

Answer 3

r↓E = Pt - Pt - 1/ (Pt -1)

Question 4

What is the trade-off between risk and return ?

Answer 4

❖Investors are typically risk averse.
❖The benefit received from an increase in income is smaller
than the cost incurred of a similar drop in income.
❖Investors will not hold a portfolio that is more volatile
unless they expected to earn a higher return.
❖Investors want to be compensated for the extra risk they hold in their portfolio.
❖So far, we know that the Treasury bill is the safest, and
stock market investments are the riskiest

Question 5

What is Systematic Risk Versus Firm-Specific Risk?

Answer 5

Common Risks
▪ Systematic risk that affects all
securities
▪Due to market-wide news
▪Also known as systematic risk,
undiversifiable risk, market risk

Independent Risks
▪ Firm specific that affects a particular security
▪Due to firm-specific news
▪Also known as firm-specific risk,
unsystematic risk, diversifiable risk

Question 6

What is portfolio theory?

Answer 6

When many stocks are combined in a large portfolio, the firm-specific risks for
each stock will average out and be diversified. This is Portfolio Theory

Question 7

How do you measure systemic risk?

Answer 7

• To measure the systematic risk of a stock, determine how much of the variability of its return is due to systematic risk versus
  unsystematic risk.
  ▪ Find a portfolio that only have systematic risk.
  ▪ Estimate the stock’s sensitivity to this portfolio

Question 8

What is the efficient portfolio?

Answer 8

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

Question 9

What is market portfolio?

Answer 9

▪ An efficient portfolio that contains all shares and securities in the market
◦ The S&P 500 (market index) is often used as a proxy for the market portfolio.
▪ If we assume that the market portfolio is efficient, the changes in the value of the market
portfolio represent system shocks to the economy