Chapter 4
Risk and Return: The Basics
ANSWERS TO ENDOFCHAPTER QUESTIONS
41
a.
Standalone risk is only a part of total risk and pertains to the risk an investor takes by
holding only one asset.
Risk is the chance that some unfavorable event will occur.
For instance, the risk of an asset is essentially the chance that the asset’s cash flows
will be unfavorable or less than expected.
A probability distribution is a listing, chart
or graph of all possible outcomes, such as expected rates of return, with a probability
assigned to each outcome.
When in graph form, the tighter the probability
distribution, the less uncertain the outcome.
b.
The expected rate of return (
∧
r
) is the expected value of a probability distribution of
expected returns.
c.
A continuous probability distribution contains an infinite number of outcomes and is
graphed from 
∞
and +
∞
.
d.
The standard deviation (σ) is a statistical measure of the variability of a set of
observations.
The variance (σ
2
) of the probability distribution is the sum of the
squared deviations about the expected value adjusted for deviation.
The coefficient
of variation (CV) is equal to the standard deviation divided by the expected return; it
is a standardized risk measure which allows comparisons between investments having
different expected returns and standard deviations.
e.
A risk averse investor dislikes risk and requires a higher rate of return as an
inducement to buy riskier securities.
A realized return is the actual return an investor
receives on their investment.
It can be quite different than their expected return.
f.
A risk premium is the difference between the rate of return on a riskfree asset and the
expected return on Stock i which has higher risk. The market risk premium is the
difference between the expected return on the market and the riskfree rate.
g.
CAPM is a model based upon the proposition that any stock’s required rate of return
is equal to the risk free rate of return plus a risk premium reflecting only the risk re
maining after diversification.
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The expected return on a portfolio.
∧
r
p
, is simply the weightedaverage expected
return of the individual stocks in the portfolio, with the weights being the fraction of
total portfolio value invested in each stock.
The market portfolio is a portfolio
consisting of all stocks.
i.
Correlation is the tendency of two variables to move together.
A correlation
coefficient (ρ) of +1.0 means that the two variables move up and down in perfect
synchronization, while a coefficient of 1.0 means the variables always move in
opposite directions.
A correlation coefficient of zero suggests that the two variables
are not related to one another; that is, they are independent.
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 Spring '11
 larson
 Interest, Risk in finance, Repo Men, Alta Inds

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