Risk and Return Relationship
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Questions and Answers

What is the purpose of a risk premium in the cost of capital?

  • To eliminate the need for any calculations in project valuation.
  • To set a discount rate based solely on historical returns.
  • To ensure that all investments provide the same return.
  • To estimate the additional return investors expect for taking on risk. (correct)

    • Why do serious investors hold diversified portfolios?

  • To guarantee maximum returns from a single stock.
  • To reduce exposure to any single investment's performance. (correct)
  • To simplify the management of their investments.
  • To eliminate all forms of market risk.

    • What does the concept of opportunity cost of capital refer to?

  • The difference between potential returns from two different investments. (correct)
  • The amount lost from failed investments.
  • The guaranteed returns on a secured investment.
  • The return from an investment that has no associated risk.

    • How do historical returns relate to expected returns for future investments?

    <p>They inform estimates through arithmetic and compound returns.</p> Signup and view all the answers

    Which of the following best defines the cost of capital?

    <p>The minimum return necessary for an investment to be worthwhile.</p> Signup and view all the answers

    In the context of portfolio risk, why is understanding covariance and correlation important?

    <p>It determines how assets move in relation to each other.</p> Signup and view all the answers

    What is one limitation imposed by diversification in investing?

    <p>It can result in lower returns if over-diversified.</p> Signup and view all the answers

    Which factor is typically used as the starting point for establishing a discount rate?

    <p>The risk-free rate, such as Treasury bills.</p> Signup and view all the answers

    What is the primary purpose of calculating covariance in a portfolio?

    <p>To measure how assets move together</p> Signup and view all the answers

    What is the typical range for historical average market risk premium when estimating expected market return?

    <p>5-8%</p> Signup and view all the answers

    Which principle explains the diminishing benefits of diversification in a stock portfolio?

    <p>Efficient diversification peaks at 20-30 stocks</p> Signup and view all the answers

    Which type of risk is primarily associated with market movements?

    <p>Systematic risk</p> Signup and view all the answers

    How do financial managers typically estimate the cost of capital for a project?

    <p>By summing the current risk-free rate and a historical market risk premium</p> Signup and view all the answers

    What do standard deviation and variance measure in the context of portfolio risk?

    <p>The dispersion of asset returns around the mean</p> Signup and view all the answers

    What is a significant limitation of relying solely on historical returns for investment decisions?

    <p>Economic and market conditions may change</p> Signup and view all the answers

    In the context of portfolio risk, what role does correlation play?

    <p>It helps in measuring diversification benefits</p> Signup and view all the answers

    What does the risk premium represent in the context of investments?

    <p>The extra return required for taking on additional risk.</p> Signup and view all the answers

    How does diversification contribute to portfolio risk reduction?

    <p>By mixing investments that do not move in perfect correlation.</p> Signup and view all the answers

    Which measure consistently indicates higher risk in terms of investment returns?

    <p>Standard deviation.</p> Signup and view all the answers

    What differentiates systematic risk from specific risk?

    <p>Systematic risk is inherent to the entire market and cannot be diversified away.</p> Signup and view all the answers

    What is the purpose of using arithmetic averages in return forecasts?

    <p>To estimate expected returns and represent opportunity costs effectively.</p> Signup and view all the answers

    Which of the following statements about covariance and correlation is true?

    <p>Both correlation and covariance provide insights into the relationship between asset returns.</p> Signup and view all the answers

    What is the effective return on an investment usually termed when considering compounding?

    <p>Compound return.</p> Signup and view all the answers

    Which option describes the cost of capital in corporate finance?

    <p>The expected return necessary to attract investors to fund future projects.</p> Signup and view all the answers

    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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    Related Documents

    Finance 1 PDF - Risk and Return Concepts

    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.

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