higher expected returns
what do you have to promise investors to get them to take on more risk
risk averse
a steeper risk return line indicates that an investor is more
risk averse
a flatter risk return line indicates that an investor is less
false (ex- people wanted to take on less risk after the recession)
true/false an average investor's willingness to take on risk doesn't vary over time
cost of obtaining capital
from a company's pov, what does the risk return line represent
cost of obtaining capital
the returns that a company has to pay investors represents what
risk
probability that the actual return from an investment is less than the expected return
stand alone basis, portfolio basis
two ways that asset risk can be analyzed
stand alone risk
the risk an investor would take on if they hold only one asset
probability distributions, expected rates of return, historical rates of return, standard deviation, coefficient of variation
5 measures of stand alone risk
probability distribution
listing of possible outcomes or events with a probability assigned to each
one of the ways to measure stand alone risk
expected rate of return
weighted average of the probability distribution of possible returns
peaked
the more __________ the probability distribution, the more likely the actual outcomes will be close to the expected value
true
true/false the higher the probability distribution, the lower the risk
standard deviation
used to quantity the tightness of a probability distribution
false (smaller)
true/false the larger the standard deviation, the lower the risk
standard deviation
a statistical measure of the variability of a set of observations
true
true/false the historical standard deviation is often used a measure of future risk
no
is the a clear answer on how far back you should pull historical data
coefficient of variation
standardized measure of the risk per unit of return
standard deviation/expected return
formula for coefficient of variation
false
true/false most investors are not risk averse
coefficient of variation
the __________ _______ ___________ provides a more meaningful measure of risk when the expected returns on 2 investments are not the same
higher
the higher a security's risk, the __________ its expected return
risk premium
difference between the expected rate of return on a given risky asset and that on a less risky asset
capital asset pricing model
a model based on the proposition that any stock's required rate of return is equal to the risk free rate plus a risk premium that reflects only the risk remaining after diversification
false (lower)
true/false the risk of stock held in a portfolio is typically higher than the stock's risk when it is held alone
portfolio
the risk and return of a stock should be analyzed in terms of how the security affects the risk and return of the ___________ in which it is held
expected return on a portfolio
weighted average of the expected returns on assets held in a portfolio
realized rates of return
returns that are actually earned during some past period
true
true/false actual returns tend to be different from expected returns
when its a risk free asset
when should the actual returns of an asset be equal to its expected return
true
true/false the portfolio risk is generally smaller than the average of the stock's standard deviations
diversification lowers it
why is portfolio risk usually smaller than the average of its stock's standard deviations
correlation
tendency of two stocks to move together
when the stock's in your portfolio are negatively correlated
when is diversification useful
false
true/false with diversification, you can completely get rid of risk
increases
portfolio risk declines as the number of stocks in the portfolio ___________
market risk
risk that remains in a portfolio after diversification has eliminated all company specific risk
nondiversifiable, systematic, beta risk
what are some other names for market risk
market portfolio
portfolio consisting of all stocks
relevant risk
the risk that remains once a stock is in a diversified portfolio that is its contribution to the portfolio's market risk
beta coefficient
measures the tendency of a stock to move up and down with the market
greater
the steeper the slope of a line, the ___________ its beta
1
beta of the average stock
beta
a stock's __________ reflects its contribution to the risk of the portfolio
market risk
the only risk that should matter to a rational, diversified investor
risk premium
additional return over the risk free rate needed to compensate investors for assuming an average amount of risk
how risk averse investors are, how risky investors think the stock market is
what determines the size of the market risk premium
historical data
analysts often look to ________ ________ to estimate the market risk premium
systematic
risk premium on individual stocks varies in a ________ manner from the market risk premium
security market line
graphical representation of an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities
inflation
risk free return rate includes a premium for expected ____________
risk aversion
slope of the security market line represents the degree of ________ ________ in the economy
risk premium
the greater the average investor's risk aversion, the greater the _______ _______ for all stocks (also the higher the required rate of return)
risk free rate of return
price of money to a riskless borrower
real risk free rate of return, inflation premium
two components of risk free rate of return
true
true/false as the expected rate of inflation increases, a premium must be added to the risk freer ate to compensate investors for the loss of purchasing power that results from inflation
true
true/false an increase in the inflation premium leads to an equal increase in the rates of return on all risky assets
horizontal
what would the security market line look like if there was no risk aversion
increase
if investors become more risk averse, the market risk premium and the required returns of securities will _________
increase
if a stock's beta increases, does its required rate of return increase or decrease
change its composition of assets and the amount of debt it uses
how can a firm change its own beta
there may be no historical relationship between stocks' returns and their betas
main concerns with betas
multivariable
some people are developing _____________ CAPM models with more explanatory variables than just beta
ex post returns
past or historical returns
ex ante returns
expected returns
income yield
return earned by investors as a periodic cash flow
capital gain
measures the appreciation (or depreciation) in the price of the asset from some starting price
total return
sum of the income yield and the capital gain yield
geometric mean
average or compound growth rate over multiple time periods
arithmetic mean
simply averages the annual rates of return without taking into account that the amount invested varies across time
when we are interested in the rate of return of an investment over time
when is the geometric mean average a better return estimate than the arithmetic mean
ex post (historical)
The expected return is often estimated based on _________ _________ averages
ex ante standard deviation
standard deviation formulated based on expectations about the future cash flows or returns of an asset
ex post standard deviation
standard deviation formulated using information that has occurred
portfolio
a collection of assets, such as stocks and bonds, that are combined and considered a single asset
efficient frontier
mix of assets that minimizes a portfolio's standard deviation lies on this
risk neutral
person who demands no extra compensation for risk
risk preferent
person who will pay to take on more risk
aversion
higher risk premiums indicate greater risk _____________
efficient frontier
the set of assets (or portfolios) that offers the Maximum level of return for the minimum level of risk
0
standard deviation of the returns of a risk free asset
0
correlation between the return on a risk free asset and that of a risky portfolio
market portfolio
a portfolio that consists of all assets in the entire economy, with the weights of these assets being the ratio of their market value to the total market value of all assets
market price of risk
trade off of risk and return for efficient portfolios
incremental expected return/incremental risk
slope of capital market line
false (only efficient portfolios)
true/false The CML provides a method of estimating the required return on assets relative to their risk and applies to both efficient portfolios (i.e. portfolios on the line) and individual securities
individual firms
in financial management we are usually concerned with the risk associated with investing in
capital asset pricing model
To estimate the expected or required return for individual firms or portfolios, we can use the
expected component, unexpected component
two components of realized returns
surprise component
which component of announcements and news affects stock's price and its returns
unsystematic risk
Risk factors that affect a limited number of assets
includes stuff like labor strikes, part shortages, etc.
systematic risk
Risk factors that affect a large number of assets (almost all assets)
includes stuff like gdp, inflation, interest rates
unique risk, asset specific risk
a couple other names for unsystematic risk
expected return + unexpected return
formula for total return
systematic portion + unsystematic portion
formula for unexpected return
systematic risk
the total risk for a diversified portfolio is essentially equivalent to just the
capital asset pricing model
model that describes expected returns in terms of the risk-free rate of interest and a premium for bearing systematic (or market) risk
capital markets are in equilibrium
one of the main CAPM assumptions
investors are only compensated for taking on systematic risk, the expected return on an asset depends on its level of systematic risk
two implications of CAPM
1
beta of the market portfolio =
0
beta of a risk free asset =
security market line
describes the relationship between risk and return in the CAPM model
(rm-rf)
formula for market risk premium
B(rm-rf)
formula for risk premium for an asset
security market line
most widely used contribution of the CAPM
market risk
only risk that an investor should care about if they have a diversified portfolio
efficient market
market in which the prices of all assets accurately reflect all relevant and available information about the assets
efficient market hypothesis
formalized the concept of an efficient market into a theory that markets are efficient, and therefore, in its strictest sense, it implies that prices accurately reflect all information at any point in time
weak form, semi strong form, strong form
3 degrees of market efficiency
weak form
form of market efficiency where Asset prices fully reflect all market data, which refers to all past price and volume trading information
semi strong form
form of market efficiency where Asset prices reflect all publicly known and available information. For stock markets this includes information about earnings, dividends, corporate investments, management changes, and so on. This also includes market data,
strong form
form of market efficiency where Asset prices fully reflect all information, which includes both public and private information.
true
true/false a market that is strong form is also semi strong form and weak form
anomaly
a mispricing of an asset such that the pricing of the asset is not consistent with efficient markets. In other words, the pricing of an asset is not associated with relevant information about the asset that is known to all market participant
size effect, january effect, momentum
few examples of anomalies