RSM332 Final Exam

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Rotman Commerce
Jennifer So

Risk and Return  Risk is defined as the "possibility of incurring harm."  Ex post returns: returns past or historical returns  Ex ante returns: returns future or expected returns  Return on investment compromises of income yield and capital gain (or loss) yield  Income yield: the return earned by investors as a periodic cash flow (interest, dividends)  CF1/P0  Capital gain (or loss): appreciation (or deprecation) in the price of the asset from some starting price  (P1 - P0) / P0  Paper losses: capital losses that people do not accept as losses until they actually sell and realize them  Mark to market: carrying securities at the current market value regardless of whether they are sold  Measuring average returns  Arithmetic mean or average: sum of all returns divided by the total number of observations  Appropriate when trying to estimate typical return for a given period  Geometric mean: the average or compound growth rate over multiple periods  Determining "true" average rate of return over multiple periods  Standard deviation: a measure of risk over all the observations; the square root of the variance  Expected returns is the sum of the probabilities of most likely returns under various scenarios Measuring risk  Standard deviation formula  Expressed as a percentage  Ex ante standard deviation sum of Prob * (return - expected)^2  Variance: the standard deviation squared Risk premium is the additional return above the risk-free rate resulting from bearing risk  Compensation for additional risk  Sometimes called excess return Expected return and risk for portfolios  Portfolio: a collection of securities, such as stocks and bonds, that are combined and considered a single asset  Modern portfolio theory (MPT): the theory that securities should be managed within a portfolio rather than individually, to create risk-reduction gains; also stipulates that investors should diversify their investments so as not to be unnecessary exposed to a single negative event  Expected return of portfolio is the weighted average of the expected returns on each individual securities  Standard deviation of portfolio  covariance: statistical measure of the correlation of the fluctuations of the annual rates of return of different investments  Strength or magnitude  Correlation coefficient: a statistical measure that identifies how security returns move in relation to one another  +1 = 1 perfect positive correlation, -1 = -1 perfect negative correlation  Lower correlation, lower the standard deviation  Diversification: process of investing funds across several securities, which results in reduced risk  Random or naïve diversification: the act of randomly buying securities without regard to relevant investment characteristics, such as company size, industry classification, and so on  Benefit does not continue indefinitely, marginal risk reduction decrease  Total risk = market + unique  Unique (non-systematic) or diversifiable risk: the company-specific part of total risk that is eliminated by diversification  Market (systematic) or non-diversifiable risk: the systematic part of total risk, directly influenced by overall movements in the general market or economy that cannot be eliminated by diversification Portfolio theory  Efficient frontier  3 security portfolio variance (page 317)  Modern portfolio theory  Assumptions  Investors are rational decision-makers  Investors are risk averse, which means they like expected returns and dislike risk and therefore require compensation to assume additional risk  Investor preferences are based on a portfolio's expected return and risk  Minimum variance frontier: the curve produced when determining the expected return-risk combinations available to investors from a given set of securities by allowing portfolio weights to vary  Attainable portfolios: portfolios that may be constructed by combining the underlying securities  Dominated portfolio: inefficient, lower expected rate of return for same risk as others  Efficient frontier: set of efficient portfolios  Efficient portfolios: those portfolios that offer the highest expected return for a given level of risk, or offer the lowest risk for a given expected return  Minimum variance portfolio (MVP): a portfolio that lies on the efficient frontier and has the minimum amount of portfolio risk available from any possible combination of available securities  Portfolio with lowest possible risk and therefore defines the lowest expected return we should be willing to accept  Alternate way to find weight in 8A and find efficient frontier  Introduction of risk-free borrowing and lending  Insurance premium: payment to get out of a risk situation  Tangent portfolio: the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate  The tangent line from Rf to this portfolio is known as the Capital Market Line (CML)  With RF and risky assets, we would never invest in any portfolio that is NOT on the CML  New (or super) efficient frontier: portfolios composed of the risk-free rate and the tangent portfolio that offer the highest expected rate of return for any given level of risk  Borrow RF and invest everything in M  Short position: a negative position in an asset; the investor achieves a short position by borrowing part of the asset's purchase price from the stockbroker  Separation theorem: the theory that investment decision (how to construct the portfolio of risky assets) is separate from the financing decision (how much should be invested or borrowed at the risk-free rate)  Market portfolio: a portfolio that contains all risk securities in the market  Everyone will choose to invest in the same risky market portfolio CAPM  Capital asset pricing model: a pricing model that uses one factor, beta, to relate expected returns to risk  Assumptions  All investors have identical expectations  No transaction costs and can borrow/end at risk free RoR  Same one period time horizon  N
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