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notes_review02_2up

notes_review02_2up - Notes Exam 2 Additional problems and...

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Exam 2 Additional problems and review Notes: 2
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What is an excess return? What is an expected return? What is a risk premium? What do we mean when we speak of the risk of a financial asset? How do we estimate it? 3 Notes: Excess return is the realized return minus the risk-free rate. Expected return is the average return I expect to receive. The risk premium is the expected return minus the risk-free rate. Risk refers to the variability of returns. It is usually measured by the standard deviation of historical returns. 4
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How might one try to estimate the expected return of a share of stock? How might one estimate the dividend growth rate to use in the dividend growth model? 5 Notes: We can estimate the expected return using the average return from historical data, CAPM or DGM. Use historical data, analysts estimates, or the retention growth model (b*ROE). 6
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What is the difference between systematic and idiosyncratic risk? Are both kinds of risk rewarded equally? How is each kind of risk measured? 7 Notes: Systematic risk affects the entire market and can not be eliminated by diversifi- cation. Idiosyncratic (or unsystematic) risk affects individual stocks or small groups of stocks and can be eliminated by diversification. According to the CAPM, only systematic risk is rewarded. Systematic risk is measured by a stock’s beta. Unsystematic risk is measured by the standard deviation of the residuals from the CAPM regression. 8
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What does “beta” refer to? What is the Security Market Line? What does the CAPM say? 9 Notes: Beta measures the systematic risk of an assset. We can estimate it using the CAPM regression. The security market line is the line relating expected return to beta The CAPM says that there is a linear relationship between expected excess returns and beta. It also says that the market portfolio is efficient. 10
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If the market risk premium is 8% and the risk-free rate is 3%, what is the expected return for a stock with a beta of 1.5 (according to the CAPM)? Suppose the distribution of daily returns for a particular asset is approximately normal with mean 5% and standard devia- tion 7%. About how likely is a return greater than 19%? 11 Notes: 3 + 1.5 x (8) = 15 2.5% of observations are expected to be greater than 2 std dev above the mean.
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