RIsk and reuturn

• What investment had the highest long-term returns according to the graphs?

  Small stocks
• What is the relationship between risk and return?

  Higher risk requires a higher return
• What are the main topics covered in the Risk and Return overview?

  • The Pricing of Risk
  • Optimal Portfolio Choice
  • CAPM
  • Alternative Models of Systematic Risk
• What does a probability distribution summarize?

  All possible returns of a risky investment
• If SHLM stock trades for $200, what is the probability of it being $216 in one year?

  25%
• How is expected return calculated in the probabilistic approach?

  As a weighted average of possible returns
• What is the expected return for SHLM calculated as?

  $E[R] =$$(.25)(.08) +$$(.55)(.10) +$$(.20)(.12)$
• What does standard deviation measure in finance?

  The volatility of a return
• What is variance in the context of risk?

  The expected squared deviation from the mean
• How do variance and standard deviation differ in measuring risk?

  Variance measures spread; SD measures volatility
• What is a problem with the probabilistic approach?

  The probability distribution is unknown in practice
• What is a realized return?

  The return that actually occurred
• How can we estimate the underlying probability distribution?

  By counting realized returns within ranges
• What is the empirical distribution?

  Probability distribution plotted using historical data
• What do we need to calculate for any distribution?

  Mean and variance
• What is the average annual return calculated from?

  Realized return of a security over years
• What is the volatility of US stocks from 1926-2017?

  39.2%
• What does the standard error (SE) measure?

  The degree of estimation error
• What does a 95% confidence interval indicate?

  True expected value is within this range
• What is a problem with estimating individual stocks' expected returns?

  Individual stocks tend to be more volatile
• What is the excess return?

  Difference between investment return and T-Bills return
• What relationship exists between risk and return?

  There is a positive relationship
• How do larger stocks compare to smaller stocks in terms of volatility?

  Larger stocks tend to have lower volatility
• What are the average annual returns and volatility for different investments from 1926-2017?

  • Small stocks: 18.7%, 39.2%
  • S&P 500: 12.0%, 19.8%
  • Corporate bonds: 6.2%, 6.4%
  • Treasury bills: 3.4%, 3.1%
• What are the issues with using historical returns for estimating expected returns?

  • Unknown past investor expectations
  • Average return is just an estimate
  • Large estimation errors for individual stocks
• What type of investments provide more stable returns?

  Investments that provide more stable returns
• Is there a positive relationship between volatility and average returns for individual stocks?

  No, there is no precise relationship
• How do individual stocks compare to large portfolios in terms of risk and returns?

  Individual stocks have higher risk and lower returns
• What is the average return and standard deviation for selected stocks in the Eurostoxx 50 from 1996-2005?

  • Average return: 0.15
  • Standard deviation: 0.17
• What can be observed from the volatility of stocks compared to their index?

  Most stocks have higher volatility than their index
• Why can a market index be less risky than individual stocks?

  Market indices average out individual stock risks
• What are the types of risk in the risk-based approach?

  • Common Risk: Affects all securities
  • Independent Risk: Affects a particular security
• What is diversification in the context of risk management?

  Averaging out independent risks in a portfolio
• What types of risks do actual firms face?

  Both market-wide risks and firm-specific risks
• What happens to unsystematic risk when stocks are combined into a portfolio?

  Only unsystematic risk is diversified
• What remains in a portfolio after diversifying unsystematic risk?

  Only systematic risk remains
• Why is the risk premium for diversifiable risk zero?

  Investors can eliminate it through diversification
• What determines the risk premium of a security?

  Its systematic risk, not diversifiable risk
• What is the efficient portfolio?

  A portfolio containing only systematic risk
• What is beta (β) in finance?

  Sensitivity of a security’s return to the market