Risk and Valuation: Course Aims and Objectives
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Questions and Answers

What is the primary objective of calculating 'ex ante' expected returns and variance of returns?

  • To understand the effect of portfolio diversification on risk (correct)
  • To determine the dividend discount model for share valuation
  • To describe the required rate of return for different shares
  • To distinguish between systematic and unsystematic risk

    • What do investors expect to receive in the future when they invest in shares now?

  • Higher returns than gilts or T-Bills
  • Lower returns than gilts or T-Bills
  • Returns commensurate with the level of risk (correct)
  • Fixed returns with no uncertainty

    • What is the primary difference between LSE shares and gilts or T-Bills?

  • LSE shares have historically delivered higher returns than gilts or T-Bills (correct)
  • LSE shares have historically delivered lower returns than gilts or T-Bills
  • LSE shares are more predictable than gilts or T-Bills
  • LSE shares are less volatile than gilts or T-Bills

    • What is the key result of portfolio diversification on risk?

    <p>It reduces the risk of the portfolio</p> Signup and view all the answers

    What determines the required rate of return for different shares?

    <p>The level of risk associated with the share</p> Signup and view all the answers

    What is the characteristic of the states of the world in this scenario?

    <p>They are both exhaustive and mutually exclusive.</p> Signup and view all the answers

    What is the primary distinction between systematic and unsystematic risk?

    <p>Systematic risk is associated with the market, while unsystematic risk is associated with the company</p> Signup and view all the answers

    What is the purpose of modeling uncertainty about future returns?

    <p>To understand the level of risk associated with the investment</p> Signup and view all the answers

    What is the expected return of an investment, denoted by E[R]?

    <p>The return that the investment is expected to generate on average.</p> Signup and view all the answers

    What is the relationship between the required rate of return and the level of risk?

    <p>The required rate of return is directly proportional to the level of risk</p> Signup and view all the answers

    What is the formula to calculate the expected return of an investment, E[R]?

    <p>E[R] = ∑π(s_i)R(s_i)</p> Signup and view all the answers

    What is the unexpected return of an investment, denoted by U?

    <p>The actual return minus the expected return.</p> Signup and view all the answers

    What is the variance of an investment, denoted by σ^2[R]?

    <p>The sum of the squared deviations of the actual returns from the expected return.</p> Signup and view all the answers

    What is the standard deviation of an investment, denoted by σ[R]?

    <p>The square root of the variance of the investment.</p> Signup and view all the answers

    What is the purpose of portfolio diversification?

    <p>To reduce the risk of an investment.</p> Signup and view all the answers

    What is the formula to calculate the standard deviation of an investment, denoted by σ[R]?

    <p>σ[R] = √(∑π(s_i)(R(s_i) - E[R])^2)</p> Signup and view all the answers

    If a portfolio consists of 5 shares, with equal investments in each, what are the portfolio weights?

    <p>1/5, 1/5, 1/5, 1/5, 1/5</p> Signup and view all the answers

    What is the total amount invested in four securities with amounts £25,000, £5,000, £10,000, and £20,000?

    <p>£60,000</p> Signup and view all the answers

    A portfolio consists of two securities with weights θ1 and θ2. What is the expected return of the portfolio?

    <p>θ1E[R1] + θ2E[R2]</p> Signup and view all the answers

    What is the formula for the standard deviation of a portfolio return?

    <p>θ1σ[R1] + θ2σ[R2] + 2θ1θ2ρ12σ[R1]σ[R2]</p> Signup and view all the answers

    What is the relationship between the standard deviation of a portfolio and the standard deviations of the constituent securities?

    <p>The standard deviation of the portfolio is always less than the standard deviations of the constituent securities.</p> Signup and view all the answers

    What is the term for the risk that can be reduced through diversification?

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

    What is the expected return of a portfolio with two securities, R1 and R2, with weights θ1 and θ2, respectively?

    <p>θ1E[R1] + θ2E[R2]</p> Signup and view all the answers

    What is the formula for the covariance between two securities, R1 and R2?

    <p>E[R1R2] - E[R1]E[R2]</p> Signup and view all the answers

    What is the component of total risk that affects individual or a small group of securities?

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

    Which of the following is an example of systematic risk?

    <p>Information surprises about interest rates</p> Signup and view all the answers

    What is the purpose of portfolio diversification?

    <p>To eliminate unsystematic risk</p> Signup and view all the answers

    What is the principle that states that investors require higher expected returns to compensate them for systematic risk?

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

    What is the formula for total risk?

    <p>R = E[R] + U</p> Signup and view all the answers

    What is the component of total risk that can be diversified away?

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

    Why do investors demand higher expected returns for riskier securities?

    <p>To compensate for systematic risk</p> Signup and view all the answers

    What is the term for the unexpected part of total risk?

    <p>Unexpected return</p> Signup and view all the answers

    What is the relationship between the expected return and systematic risk of a security according to the systematic risk principle?

    <p>Securities with higher systematic risk promise higher expected returns</p> Signup and view all the answers

    What is the sum of the portfolio weights in a portfolio?

    <p>Equal to 1</p> Signup and view all the answers

    What is the effect of diversification on the portfolio's risk?

    <p>It decreases the portfolio's risk</p> Signup and view all the answers

    How is the portfolio's standard deviation related to the standard deviation of its constituent securities?

    <p>It is always less than the weighted average of the standard deviations of the constituent securities</p> Signup and view all the answers

    What is the name of the principle that states that security prices are determined so that securities with higher systematic risk promise higher expected returns?

    <p>The systematic risk principle</p> Signup and view all the answers

    What is the result of combining securities with high total risk and low systematic risk, such as biotechnology and internet stocks, in a portfolio?

    <p>The portfolio's total risk increases, but its systematic risk decreases</p> Signup and view all the answers

    What is the purpose of modeling uncertain returns by their return in different states of the world?

    <p>To understand the behavior of a security's returns in different economic scenarios</p> Signup and view all the answers

    What is the relationship between the portfolio's expected return and the expected returns of its constituent securities?

    <p>The portfolio's expected return is a weighted average of the expected returns of its constituent securities</p> Signup and view all the answers

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