Questions and Answers
What are the two key financial considerations in important business decisions?
Risk and return
How is risk defined in the context of investments?
Risk is a measure of the uncertainty surrounding the return that an investment will earn.
What is the formula for calculating the total rate of return earned on any asset?
rt = (Ct + Pt - Pt-1) / Pt-1
What is the expected return of an asset based on past performance?
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Which of the following describes a risk-averse investor?
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What does scenario analysis involve in assessing risk?
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What is the significance of diversification in risk management?
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What does correlation measure in the context of portfolio assets?
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What does the Capital Asset Pricing Model (CAPM) quantify?
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What is meant by nondiversifiable risk?
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Study Notes
Risk and Return Fundamentals
- Key financial decisions involve evaluating risk and return.
- Risk: Measure of uncertainty in investment returns; variability in returns associated with an asset.
- Return: Total gain or loss from an investment over a specific period.
- Rate of return formula: ( r_t = \frac{C_t + (P_t - P_{t-1})}{P_{t-1}} ).
Understanding Risk
- Risk preferences categorize investors as:
- Risk Averse: Require higher returns for increased risk.
- Risk-Neutral: Prefer higher returns regardless of associated risks.
- Risk-Seeking: Favor riskier investments even with lower expected returns.
Single Asset Risk Assessment
- Scenario analysis evaluates risk using various possible outcomes: pessimistic, most likely, and optimistic.
- Range: Calculated as the difference between optimistic and pessimistic returns.
- Probability distributions associate probabilities with potential outcomes, helping assess risk.
Risk Measurement
- Standard deviation (( \sigma_r )): Indicates dispersion around the expected return; higher standard deviation signifies greater risk.
- Coefficient of Variation (CV): Measures the relative dispersion relative to expected return; useful for comparing different assets.
Portfolio Risk
- Portfolio risk assessment considers existing assets when evaluating new investments.
- Efficient Portfolio: Aims for maximum returns with a given level of risk.
- Portfolio return: Weighted average of individual asset returns, accounting for each asset's percentage in the portfolio.
Correlation and Diversification
- Correlation: Indicates the relationship between two assets; can be positive, negative, or uncorrelated.
- Diversification reduces overall portfolio risk by combining assets with low correlations.
International Diversification
- Adding international assets tends to improve portfolio performance by reducing correlation with domestic market movements.
- Unique risks in international investing include currency and political risks.
Capital Asset Pricing Model (CAPM)
- CAPM: Links risk (beta) and return, quantifying expected additional return per unit of risk.
- Total risk consists of diversifiable (firm-specific) and non-diversifiable (market) risk.
- Beta coefficient measures an asset's non-diversifiable risk in relation to market movements.
CAPM Formula
- ( r_j = R_F + [b_j \times (r_m - R_F)] )
- Historical returns and market performance guide the estimation of required returns.
Security Market Line (SML)
- Visual representation of CAPM showing the required return across various levels of non-diversifiable risk (beta).
- Shifts in SML can occur due to changes in inflation or shifts in risk aversion among investors.
Important Considerations
- CAPM relies on historical data, which may not accurately predict future variability.
- Assumes market efficiency, which while idealistic, is supported by observations in active markets like the NYSE.
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Description
This quiz focuses on the fundamental concepts of risk and return in finance. You'll learn about the procedures for assessing the risk of assets, measuring returns, and the significance of diversification and correlation in portfolio management. Prepare to delve into the intricate relationship between risk preferences and return characteristics.
