FI 410 Final Exam Study Guide
FI 410 Final Exam Study Guide
Chapter 2 and 3:
Investment risk- pertains to the probability of earning a return less than that expected.
Standard deviation measures the stand-alone risk of an investment
The larger the std deviation, the higher the probability that returns will be far below the expected return
Two-Stock Portfolios:
Can be combined to form a risklss portfolio if correlation (p)= -1.0
Risk is not reduced at all if the two stocks have correlation (p)= +1.0
In general, stocks have an approx.. correlation (p)= 0.35, so risk lowered but not eliminated
What happens when adding stocks to a n average 1-stock portfolio?
Standard deviation of the portfolio would decrease because the added stocks would not be perfectly correlated
The expected portfolio rate of return would remain relatively constant
Stand-alone risk, standard deviation of the portfolio, is reduced as the number of stocks in a portfolio increase
Standard deviation of the portfolio falls very slowly after about 40 stocks
Lower limit for standard deviation of a portfolio is about 20%= market risk
Stand-alone risk= Market risk + Diversifiable risk
Market risk is the part of a securities stand-alone risk that cannot be eliminated by diversification
Firm-specific, or diversifiable, risk is the part of a security’s stand-alone risk that can be eliminated by diversification
Market risk is measured by a stock’s beta coefficient:
Beta is also defined as the slope of a regression line
If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than average.
Most stocks have betas from 0.5 to 1.5
The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM)
SML: ri = rRF + (RPM)bi
RPM = (rM - rRF)
Inflation increases the rM by however much I equals (ex. I= 3%, rM increases 3%). Slope remains the same. Moves entire SML.
Impact of Risk Aversion: if RPM increases 3%, slope increases to make RPM increase by 3%. Slope increases instead of
Chapter 2 and 3:
Investment risk- pertains to the probability of earning a return less than that expected.
Standard deviation measures the stand-alone risk of an investment
The larger the std deviation, the higher the probability that returns will be far below the expected return
Two-Stock Portfolios:
Can be combined to form a risklss portfolio if correlation (p)= -1.0
Risk is not reduced at all if the two stocks have correlation (p)= +1.0
In general, stocks have an approx.. correlation (p)= 0.35, so risk lowered but not eliminated
What happens when adding stocks to a n average 1-stock portfolio?
Standard deviation of the portfolio would decrease because the added stocks would not be perfectly correlated
The expected portfolio rate of return would remain relatively constant
Stand-alone risk, standard deviation of the portfolio, is reduced as the number of stocks in a portfolio increase
Standard deviation of the portfolio falls very slowly after about 40 stocks
Lower limit for standard deviation of a portfolio is about 20%= market risk
Stand-alone risk= Market risk + Diversifiable risk
Market risk is the part of a securities stand-alone risk that cannot be eliminated by diversification
Firm-specific, or diversifiable, risk is the part of a security’s stand-alone risk that can be eliminated by diversification
Market risk is measured by a stock’s beta coefficient:
Beta is also defined as the slope of a regression line
If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than average.
Most stocks have betas from 0.5 to 1.5
The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM)
SML: ri = rRF + (RPM)bi
RPM = (rM - rRF)
Inflation increases the rM by however much I equals (ex. I= 3%, rM increases 3%). Slope remains the same. Moves entire SML.
Impact of Risk Aversion: if RPM increases 3%, slope increases to make RPM increase by 3%. Slope increases instead of