Chapter 6: The Meaning and Measurement of Risk and Return

Multiple Choice

This activity contains 10 questions. We need all of the following information in order to determine the expected return on an investment except: Possible future states of the economy. Probability of different future states of the economy occurring. Profits in the future states. Cash flows in the future states.

What will be the expected return on a stock if there is an equal probability of the stock rising or falling by 10%? 0% We need more information. 10% 20%

Risk in an investment can be defined as: Potential variability in future cash flows. Dispersion of returns around the mean or expected return measured by standard deviation. Returns not adequate to compensate for inflation. #1 and #2.

Historical data shows the following is the correct ordering of returns on financial securities (from highest to the lowest). Treasury Bills, Government Bonds, Corporate Bonds, Common Stocks. Corporate Bonds, Common Stocks, Government Bonds, Treasury Bills. Common Stocks, Corporate Bonds, Government Bonds, Treasury Bills. Common Stocks, Government Bonds, Corporate Bonds, Treasury Bills.
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Chapter 6: The Meaning and Measurement of Risk and Return

The following security has provided the best hedge against inflation in the long-run: Corporate Bonds. Treasury Bills. Common Stocks. U.S. Government Bonds.

Market risk cannot be diversified away because: An individual investor cannot hold all the stocks in the market. All firms are exposed to market risk. Market risk cannot be measured. Market risk cannot be forecasted.

The closing price of XYZ was $22 on January 1 and $16 on February 1. The one-month holding period return (before any costs) is: -.27% .375% -27.27% 37.5%

If the slope of the characteristics line for stock XYZ is 1.5 it means the following: It means that if stock XYZ returns increase by 1%, the return for market will, on average, increase by 1.5%. It means that as the market return increases or decreases by 1%, the return for XYZ stock on average increases or decreases 1.5%. The standard deviation of stock XYZ is 1.5%. XYZ stock is 1.5 times as risky as the market index.

Chapter 6: The Meaning and Measurement of Risk and Return

Investor's required rate of return according to CAPM equals: Risk free rate - Beta*(Market Return - Risk free rate). Beta*(Market return - Risk free rate). Risk free rate + Beta*(Market Return - Risk free rate). Risk free rate + Beta*(Market Return + Risk free rate).

XYZ stock has a beta of zero. If the risk-free rate is 3% and the return on market is 12%, XYZ stock should have the following required rate of return: 0% 3% 9% 15%

Answers 1. Profits in the future states. We need to make an assessment of the probability of different future states of the economy occurring. 2. Answer is 0% This is the correct answer. Expected Return is computed as follows. Expected Return % = (Probability * Return% when stock rises) + (Probability * Return% when stock falls) = (.5*10) + (.5* - 10) = 0%. ______________________________________________________________________________ 3. Answer #1 and #2. Answer is #4. While not being able to earn a rate of return equivalent to inflation will be a loss and a source of concern, a more appropriate answer will be #4.
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Chapter 6: The Meaning and Measurement of Risk and Return

4. Common Stocks, Corporate Bonds, Government Bonds, Treasury Bills.

The order reflects the direct relationship between risk and return.

______________________________________________________________________________ 5. Common Stocks. Common stocks had the highest average real annual return of 9.3% for the period 1926 to 2000. Treasury bills provided only .7%. ______________________________________________________________________________ 6. All firms are exposed to market risk. answer is #2. Market risk cannot be diversified even if the investor could afford to buy all the stocks in the market. Market risk cannot be diversified as it tends to affect all firms such as changes in interest rate, changes in tax rate, change in government.

7. The closing price of XYZ was $22 on January 1 and $16 on February 1. The one-month holding period return (before any costs) is: answer is #3. It is found as follows. Holding period return = (Feb 1 price/Jan 1 price) - 1 = (16/22) - 1 = -0.2727 or -27.27%. ______________________________________________________________________________ 8. It means that as the market return increases or decreases by 1%, the return for XYZ stock on average increases or decreases 1.5%. answer is #2. It means that as the market return increases or decreases by 1%, the return for XYZ stock on average increases or decreases 1.5%.

9. Risk free rate + Beta*(Market Return - Risk free rate).

______________________________________________________________________________
10. Answer is 3%
Answer is #2. It is computed as follows. Required rate of return = Risk free rate + Beta*(Market Return Risk free rate) = 3% + 0 *(9%) = 3%. _____________________________________________________________________________________

Chapter 6: The Meaning and Measurement of Risk and Return

True or False

This activity contains 10 questions.

Expected return on a stock is a reliable indicator of how well the stock will perform in the future.
True False

Assume a project required an investment of $20,000 and is expected to generate $1,000 in a particular scenario. The expected return for this scenario will be 5%.
True False

If an investment has high risk, it will have a relatively wider standard deviation compared to an investment that has low risk.
True False

Since risk refers to uncertainty of future cash flows, it cannot be measured accurately.
True False

Historical evidence shows that low-risk securities such as treasury bills do not provide an adequate inflation hedge.
True False

Since treasury bills are risk-free, the standard deviation will equal zero.
True False
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Chapter 6: The Meaning and Measurement of Risk and Return

With effective diversification, market risk can be eliminated.

True False

Beta measures the relationship between a firm's stock returns and returns of other firms in the industry.
True False

According to CAPM, if a stock has a beta of zero, the required rate of return will be equal to zero.
True False

A stock has a beta of 1.5 and risk premium of 12%. If the risk-free rate is 5%, the required rate of return will equal 17%.
True False

Answers
1. False
Expected return merely provides an educated guess on future performance of a stock. It cannot be a very reliable indicator as all the information used for estimating the expected return is determined subjectively. _____________________________________________________________________________________

2. True
The correct answer is true. Expected return % is computed as follows: (1000/20000) = .05 or 5%. _____________________________________________________________________________________

3. True
Standard deviation is a measure of risk and wider the standard deviation, wider the dispersion from the mean or higher the uncertainty of future return.
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Chapter 6: The Meaning and Measurement of Risk and Return

4. True
While there are different ways of quantifying risk, none of them can give us an accurate forecast of future. _____________________________________________________________________________________ 5. True Historical evidence shows that, in the long-run, only common stocks served as an inflation hedge. The real average annual return and risk premium on treasury bills was .7% and 0% respectively compared to 9.3% and 8.6% for common stocks. _____________________________________________________________________________________

6. False U.S. treasury bills are free of default risk but they still have risk. For example, during the 19262000 period, the standard deviation of treasury bills was 3.1%.

7. False Only company-unique risk or unsystematic risk can be diversified. Market risk is non diversifiable risk and cannot be eliminated through random diversification.

8. False
Beta measures the relationship between a stock's returns and the market's returns. The U.S. market is usually proxied by S&P 500 index. _____________________________________________________________________________________

9. False If beta is equal to zero, the required rate of return will be equal to the risk-free rate.
_____________________________________________________________________________________

10. True Using CAPM, required rate of return is = risk free rate + Beta * Risk premium = 5% + 1.5*12% = 23%. ______________________________________________________________________________
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Chapter 6: The Meaning and Measurement of Risk and Return

Essay This activity contains 4 questions 1. What lessons can an investor learn by reviewing the historical data on the performance of securities?

2. Discuss the relationship between risk and return. What are some ways of measuring risk and return? Does a return of 20% indicate good return? Discuss.

3. What are the two main types of risk? What role does effective diversification play in managing risk-return trade-off? Why can we say that buying lottery tickets is an irrational decision?

4. Review the ten principles introduced in chapter 1. Discuss the principle highlighted in this chapter?

Chapter 6: The Meaning and Measurement of Risk and Return

Answers 1. An investor wishing to invest in the financial market can learn much by reviewing the historical data. The following are some of the lessons that an investor can learn: 1. There is a direct relationship between risk and return: Historical data clearly demonstrates that there is a direct relationship between risk and return. Thus an investor wishing to increase his or her return must necessarily take more risk. 2. It is smart to diversify: Historical data shows that it is good for investors to diversify as no stocks are proven winners. In an efficient market, one cannot forecast performance. Thus it is prudent to diversify to minimize potential losses. 3. Higher risk does not guarantee higher return: Historical data shows that higher risk does not always lead to higher return. In the long-run, stock market may provide a higher return but in the short-run anything can happen. For example, during the 1926-2005 period, common stockholders of large firms received negative returns in 22 of the 80 years. Thus in some years, it may be better to leave our savings in the bank rather than invest in the stock market. 4. Asset allocation matters: Asset allocation refers to deciding how to allocate investible wealth in different markets. If investors wish to have superior portfolio performance, they should be able to allocate their savings well among the various groups of financial securities such as Treasury bills, Bonds, and Common stocks. Since performance for different markets vary every year, choosing the right mix can have a significant impact on performance. Thus if the bond market is expected to outperform the stock market, the investor should have the foresight to allocate more funds in the bond market that year.

2. Return can be regarded as expected or actual payoff from an investment. Thus if you buy a stock for $100 and sell it a year later for $110, the return is $10 or 10% (before any transaction cost and taxes). Risk is the uncertainty of future payoff. Thus if you buy a stock for $100 today, the price next year is unknown - it could be equal to/under/over $100. The payoff is unknown and that is risk. Greater the range of possible payoffs, greater the risk. Not surprisingly, stocks are considered more risky than bonds as stock prices, in general, are subject to wider variations. Risk and return go hand in hand and it will be foolish to focus on one while ignoring the other. Historical evidence reveals that, in general, higher the risk higher will be the expected return. The two most popular ways of measuring risk are standard deviation and beta. Standard deviation measures the degree of deviation of the returns around the mean return and is a measure of total risk while beta gives an indication of risk relative to a market index. Returns are measured either as holding period return (historical return) or expected return (future return). A return of 20% may or may not be good. In order to make an evaluation, we will need to ask several questions such as: over what time period was 20% earned? (obviously earning 20% over a 30-year period is no good!), what was the return on alternate investments during the same period? (obviously, if similar stocks earned 35%, 20% is not great), Does the return represent
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Chapter 6: The Meaning and Measurement of Risk and Return

nominal or real return? (obviously, if inflation was 27%, 20% return is not good enough), Does the return indicate net return after all transaction costs and taxes? (if taxes and costs wipe out the profits, 20% may not be as good), What was the level of risk involved (it may be possible to increase return by increasing risk, but a high risk may not be desirable to some investors)?

3. From an investment perspective, one is exposed to two types of risk: (a) unsystematic risk risk that is specific or unique to a firm such as business failure, labour strikes, death of top executive; and (b) systematic risk - risk that tends to affect the all firms such as inflation, interest rate changes, tax rate changes, regulatory changes. Effective diversification can help to minimize (and even eliminate) unsystematic risk. Diversification is reduction in portfolio's risk that occurs when the assets are combined into a portfolio. As a result, portions of the risk of the portfolio's individual assets cancel each other out. If diversification principle were not to hold, all insurance companies would have gone bankrupt or the insurance premium would have been very high. It is unlikely that all cars will get into an accident in the same year and hence, the insurance companies are able to provide insurance at a very low premium. Due to diversification, the total risk of their portfolio of customers is very low (even though the risk for a particular car driver may be quite high). The same principle applies to stocks ... the overall risk of the portfolio is reduced as we add stocks to the portfolio. The degree of reduction in risk will depend upon how the different assets in the portfolio are related to each other and is measured by computing covariance and correlation. Effective diversification allows investors to reduce total risk without reducing expected return or to increase expected return without taking more risk. In finance, we assume that investors are risk averse i.e. investors will not take additional risk unless they are adequately compensated for it. Buying lottery tickets may be considered irrational because the expected return on lottery tickets is negative. Thus from a purely financial perspective it reflects an anomaly or irrational behaviour.

4. This chapter clearly demonstrates principle 1: The risk-return trade-off - we won't take additional risk unless we expect to be compensated with additional return. This principle is found to be true as we compare the risk-return trade-off of different financial securities. Historical evidence supports the direct relationship between risk and return. Investors are attracted to securities with higher risk as they also offer the possibility of higher return. Thus corporations cannot hope to attract funds from investors if they offer the same rate of return as banks or risk-free Treasury bills ____________________________________________________________________________________ .

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