FI 410 Final Exam Study Guide
Chapter 2 and 3:
Investment risk- pertains to the probability of earning a return less than that expected.
Standard deviation measures the stand-alone risk of an investment The larger the std deviation, the higher the probability that returns will be far below the expected return Two-Stock Portfolios:
Can be combined to form a risklss portfolio if correlation (p)= -1.0 Risk is not reduced at all if the two stocks have correlation (p)= +1.0 In general, stocks have an approx.. correlation (p)= 0.35, so risk lowered but not eliminated What happens when adding stocks to a n average 1-stock portfolio? Standard deviation of the portfolio would decrease because the added stocks would not be perfectly correlated The expected portfolio rate of return would remain relatively constant Stand-alone risk, standard deviation of the portfolio, is reduced as the number of stocks in a portfolio increase Standard deviation of the portfolio falls very slowly after about 40 stocks Lower limit for standard deviation of a portfolio is about 20%= market risk Stand-alone risk= Market risk + Diversifiable risk
Market risk is the part of a securities stand-alone risk that cannot be eliminated by diversification Firm-specific, or diversifiable, risk is the part of a security’s stand-alone risk that can be eliminated by diversification Market risk is measured by a stock’s beta coefficient:
Beta is also defined as the slope of a regression line
If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than average.
Most stocks have betas from 0.5 to 1.5
The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM) SML: ri = rRF + (RPM)bi
RPM = (rM - rRF)
Inflation increases the rM by however much I equals (ex. I= 3%, rM increases 3%). Slope remains the same. Moves entire SML. Impact of Risk Aversion: if RPM increases 3%, slope increases to make RPM increase by 3%. Slope increases instead of shift in line. CAPM has not been completely confirmed or refuted. The statistical tests have problems that make empirical verification or rejection virtually impossible. Investors required returns are based on future risk but betas are calculated with historical data. Investors may be concerned about both stand-alone and market risk. Indifference curves- reflect an investor’s attitude toward risk as reflected in his or her risk/return tradeoff function. Differ among investors.
An investor’s optimal portfolio is defined by the tangency point between the efficient set and the investors indifference curve. The steeper the indifference curve, the more risk averse an investor is Anything above the Efficient Set Curve is unattainable; anything below is feasible but not ideal.
CAPM- an equilibrium model that specifies the relationship between risk and required rate of return for assets held in well-diversified portfolios. Based on the premise that only market risk affects it. CAPM assumptions (many unrealistic): Investors all think in terms of a single holding period.
All investors have identical expectations.
Investors can borrow or lend unlimited amounts at the risk-free rate. All assets are perfectly divisible
There are no taxes and no transactions costs.
All investors are price takers, that is, investors’ buying and selling won’t influence stock prices. Quantities of all assets are given and fixed.
Adding a risk-free asset changes efficient frontier from a curve to a straight line Capital Market Line (CML) All investors choose point M. Investors that are risk averse will borrow at risk free rate, less risk averse will lend at that rate. Capital Market Line (CML)- all linear combinations of the risk-free asset and Portfolio M.
Portfolios below the CML are inferior
The CML defines the new efficient set
ALL investors will choose a portfolio on the CML
The expected rate of return on any efficient portfolio is equal to the risk-free rate...
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