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Finance Chpt 6

Risk, return and the opportunity cost of capital

QuestionAnswer
Market index definition & the two types Measure of the investment performance of the overall market Dow- value of a portfolio holding one share in each of 30 large indstl firms S&P 500 - value of a portfolio holding shares in 500 firms. Holdings are proportional to the # of shares in the issu
Which is riskier? Common stocks, T-bills & t-bonds Risk: common stocks > long treasury bonds > treasury bills
Risk premium Expected return in excess of riskfree return as compensation for risk
Maturity premium Extra average return from investing in long versus short-term Treasury securities
Variance Average value of squared deviations from mean. A measure of volatility.
Standard Deviation Average value of squared deviations from mean. A measure of volatility
Diversification Strategy designed to reduce risk by spreading the portfolio across many investments. (diversification reduces variability) Portfolio diversification works because prices of different stocks do not move exactly together.
Unique Risk Risk factors affecting only that firm. Also called “diversifiable risk.”
Market Risk Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”
The SD of returns is higher on individual stocks than it is on the market because Individual stocks do not move in exact lockstep, much of their risk can be diversified away. By spreading your portfolio across many investments, you smooth out the risk of your overall position.
The risk of the overall portfolio can be measured by The volatility of returns, that is, the variance or standard deviation.
Market risk (systematic risk) Stems from economy wide sources of risk that affect overall stock market; cannot be eliminated by diversification
Unique risk (diversifiable risk) Affect only individual firm; can be diversified. For a single stock, unique risk does matter. For a portfolio of 30/+ stocks, diversification has eliminate some risk. For a reasonably well-diversified portfolio, only market risk matters.
Created by: wguate
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