Financial Securities Module 1: Risk and Return

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Questions and Answers

What is the expected return on your portfolio calculated using the formula $E(R) = (0.60 * 15) + (0.40 * 10)$?

13%

What is the standard deviation of returns for Amazon?

26.6%

What is the standard deviation of returns for Southwest Airlines?

27.9%

What does a beta of 1 imply about a stock's return?

It moves with the market. Signup and view all the answers

A correlation coefficient of -1 is achievable among investments.

False Signup and view all the answers

What does a beta less than 1 indicate?

Lower risk compared to the market. Signup and view all the answers

What is the benchmark for comparing personal portfolios according to the content?

PSEi Signup and view all the answers

Which of the following statements is true about stocks with betas greater than 1.0?

They tend to amplify the overall movement of the market. Signup and view all the answers

What is the primary measure of market risk?

Beta Signup and view all the answers

What is a portfolio of Treasury bills?

US government debt securities maturing in less than one year. Signup and view all the answers

Which of the following statements are true regarding the riskiness of cash flows?

The riskier the cash flows, the riskier the asset. Signup and view all the answers

What type of asset is considered least risky?

Treasury bills Signup and view all the answers

Common stocks offer fixed coupon payments.

False Signup and view all the answers

What does the term 'capital gains' refer to?

Increase in stock price over time Signup and view all the answers

What happens to bond prices when interest rates rise?

Bond prices fall. Signup and view all the answers

How much was the average return provided by Treasury bills from 1900-2017?

3.8% nominal Signup and view all the answers

What is the formula to calculate the market return?

rm = 3.8% + 7.7% Signup and view all the answers

Market risk refers to _____ sources of risk that affect the overall market.

economy wide Signup and view all the answers

Match the following financial terms with their definitions:

Risk premium = Additional return expected for taking on more risk. Nominal return = The return unadjusted for inflation. Standard deviation = A measure of the volatility of an asset. Diversification = A strategy to spread risk across multiple investments. Signup and view all the answers

What is expected return based on?

The anticipated profit from an investment over a given period. Signup and view all the answers

Study Notes

Risk and Return

Treasury bills (T-bills) are short-term U.S. government debt securities that mature in less than one year, traditionally seen as a low-risk investment.
Cash flows determine the riskiness of an asset; riskier cash flows indicate a riskier asset.
Financial assets include stocks and bonds, posing different risk levels compared to real assets like machinery or whole businesses.
Common stocks represent ownership in a company, allowing stockholders to vote and receive dividends when the company is profitable.
Capital gains occur when a stock's price increases, while losses happen when prices drop.

Financial Securities Overview

Financial securities, or financial instruments, represent the right to receive future benefits under specified conditions (examples: stocks, bonds).
Bonds are debt instruments; their prices fluctuate with interest rates (rise in rates causes bond prices to fall).
Treasury bills are considered risk-free due to low default risk, given that the government generally does not go bankrupt.

Returns on Investment

Returns on different securities vary; from 1900-2017, Treasury bills yielded an average nominal return of 3.8%, while common stocks averaged 11.5%.
To calculate expected market return, add the risk-free rate (T-bill rate) to the risk premium: ( r_m = 3.8% + 7.7% = 11.5% ).
Risk premium reflects the additional return expected for taking on more risk compared to low-risk securities.

Risk Measurement and Management

Risk is the likelihood that actual gains will differ from expected returns; standard deviation is a common measure of this volatility.
Diversification reduces risk by spreading investments across various assets, minimizing the impact of poor performance in any single asset.
Market risk, or systematic risk, cannot be eliminated through diversification and affects all investors during market-wide declines.

Portfolio Composition

A portfolio mixes different asset types; diversity in investments reduces the overall risk.
Positive correlation means assets move in the same direction as the market, whereas negative correlation means they move in opposite directions.
To assess a portfolio's expected returns, weigh each investment's return by its percentage of the total portfolio.

Beta and Market Risk

Beta measures an asset's risk in relation to the overall market; a higher beta indicates greater volatility and potential for higher returns, while a lower beta indicates less risk.
The market portfolio represents all assets, with indices like the S&P Composite acting as benchmarks for overall market performance.

Key Figures and Concepts

Investors benefit from riskier assets, reflected in greater returns; however, these come with higher volatility.
Long-term government bonds (T-bonds) are viewed as less risky compared to common stocks, which can experience significant price fluctuations.
Risk management strategies are crucial for both individual investors and firms to navigate market uncertainties effectively.### Portfolio Variance and Risk
Portfolio variance can be calculated using correlation coefficients and the standard deviations of individual assets.
A correlation coefficient of 0.26 suggests a weak positive relationship between two variables in the Philippine market.
If the Philippine market declines, the Philippine Stock Exchange Index (PSEi) is expected to decline as well.

Understanding Beta

Beta measures the sensitivity of a stock's return compared to the market portfolio.
A beta of 1 indicates that a stock moves in tandem with the market.
Stocks with a beta greater than 1 indicate higher risk, moving more than the market.
A beta less than 1 suggests lower risk, less sensitivity to market movements.

Investment Example

Investing 60% in Southwest Airlines with a return of 15% and 40% in Amazon with a return of 10%.
The standard deviations of returns are 26.6% for Amazon and 27.9% for Southwest Airlines.
A correlation coefficient of -1 implies a perfectly negative relationship, impacting the overall portfolio variance calculation.

Diversification and Beta

A well-diversified portfolio typically has a beta around 1, mirroring market standard deviation at 20%.
Portfolios with beta 1.5 have higher standard deviations (30%), while those with beta 0.5 are less volatile (10%).
Stocks with betas above 1 amplify market movements, while those between 0 and 1 follow overall trends.

Portfolio Performance Evaluation

It's crucial to benchmark personal portfolios against market performance, specifically using the PSEi as a reference.
A personal portfolio's growth should ideally align with that of the market; for example, if the market earns 5% but the portfolio earns only 3%, the performance is subpar.

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Description

Explore the fundamentals of financial securities in the U.S. market, specifically focusing on risk and return in this first module. Learn about Treasury bills and government bonds as crucial components of investment portfolios. This quiz will help you understand how risk is assessed and managed in financial contexts.