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Questions and Answers
What is the purpose of a risk premium in the cost of capital?
What is the purpose of a risk premium in the cost of capital?
Why do serious investors hold diversified portfolios?
Why do serious investors hold diversified portfolios?
What does the concept of opportunity cost of capital refer to?
What does the concept of opportunity cost of capital refer to?
How do historical returns relate to expected returns for future investments?
How do historical returns relate to expected returns for future investments?
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Which of the following best defines the cost of capital?
Which of the following best defines the cost of capital?
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In the context of portfolio risk, why is understanding covariance and correlation important?
In the context of portfolio risk, why is understanding covariance and correlation important?
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What is one limitation imposed by diversification in investing?
What is one limitation imposed by diversification in investing?
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Which factor is typically used as the starting point for establishing a discount rate?
Which factor is typically used as the starting point for establishing a discount rate?
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What is the primary purpose of calculating covariance in a portfolio?
What is the primary purpose of calculating covariance in a portfolio?
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What is the typical range for historical average market risk premium when estimating expected market return?
What is the typical range for historical average market risk premium when estimating expected market return?
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Which principle explains the diminishing benefits of diversification in a stock portfolio?
Which principle explains the diminishing benefits of diversification in a stock portfolio?
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Which type of risk is primarily associated with market movements?
Which type of risk is primarily associated with market movements?
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How do financial managers typically estimate the cost of capital for a project?
How do financial managers typically estimate the cost of capital for a project?
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What do standard deviation and variance measure in the context of portfolio risk?
What do standard deviation and variance measure in the context of portfolio risk?
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What is a significant limitation of relying solely on historical returns for investment decisions?
What is a significant limitation of relying solely on historical returns for investment decisions?
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In the context of portfolio risk, what role does correlation play?
In the context of portfolio risk, what role does correlation play?
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What does the risk premium represent in the context of investments?
What does the risk premium represent in the context of investments?
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How does diversification contribute to portfolio risk reduction?
How does diversification contribute to portfolio risk reduction?
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Which measure consistently indicates higher risk in terms of investment returns?
Which measure consistently indicates higher risk in terms of investment returns?
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What differentiates systematic risk from specific risk?
What differentiates systematic risk from specific risk?
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What is the purpose of using arithmetic averages in return forecasts?
What is the purpose of using arithmetic averages in return forecasts?
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Which of the following statements about covariance and correlation is true?
Which of the following statements about covariance and correlation is true?
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What is the effective return on an investment usually termed when considering compounding?
What is the effective return on an investment usually termed when considering compounding?
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Which option describes the cost of capital in corporate finance?
Which option describes the cost of capital in corporate finance?
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Study Notes
Risk and Return Relationship
- Risk Premium: The extra return investors demand for holding risky assets compared to risk-free assets like U.S. Treasury bills.
- Historical Data on Returns: Stocks tend to generate higher returns than risk-free assets due to their higher risk, evidenced by the risk premium earned over Treasury bills.
- Arithmetic vs. Compound Returns: Arithmetic average calculates the mean annual return, while compound return calculates the effective annual growth rate. Arithmetic average is more suitable for calculating the opportunity cost of capital, especially for year-to-year return forecasts.
Risk Measures:
- Standard Deviation: Measures the volatility of returns, indicating risk. Higher standard deviation implies higher risk.
- Variance: The average of squared deviations from the mean return – another way to measure volatility. Standard deviation is the square root of the variance.
Portfolio Diversification
- Portfolio Risk Reduction: Diversifying investments minimizes risk by holding assets that don't move in perfect unison.
- Correlation: The relationship between asset returns determines the effectiveness of diversification. If assets are not perfectly correlated, the combined portfolio risk is lower than the average of individual risks.
- Systematic Risk (Market Risk): This risk is inherent to the overall market and cannot be diversified away, examples include economic downturns.
- Specific (Idiosyncratic) Risk: This risk is unique to a specific company or industry and can be reduced or eliminated by diversification.
Cost of Capital and Discount Rates
- Cost of Capital: The minimum return an investment needs to achieve to be worthwhile.
- Risk Premium in Cost of Capital: Companies use a risk-free rate (like Treasury bills) as a base and add a risk premium to account for market risk. This helps them estimate the return investors expect for taking on additional risk.
- Opportunity Cost of Capital: The return you forfeit by investing in one option instead of another.
Calculating Portfolio Risk:
- Covariance and Correlation: The risk of a portfolio with multiple assets depends on the correlation between their returns. Covariance measures how much the assets move together, while correlation is a standardized version of covariance.
- Efficient Diversification: Portfolios of around 20-30 stocks can significantly reduce risk. Beyond this point, the benefits of diversification diminish.
Market Risk Premium and Cost of Capital
- Estimating Expected Market Return: Financial managers use the current risk-free rate and a historical average market risk premium (typically between 5-8%) to evaluate a project's cost of capital.
- Factors Affecting Market Premium: Historical returns are not entirely reliable for future prediction due to economic and market changes, investor sentiment, and structural shifts in markets.
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Description
Explore the concepts of risk premium, the historical data on stock returns versus risk-free assets, and the distinctions between arithmetic and compound returns. Additionally, dive into risk measures such as standard deviation and variance, along with the principles of portfolio diversification. Test your understanding of these crucial investment topics.
