Fi 410 Final Exam Study Guide

FI 410 Final Exam Study Guide

Chapter 2 and 3:

* Investment risk- pertains to the probability of earning a return less than that expected.

*

* Standard deviation measures the stand-alone risk of an investment

* The larger the std deviation, the higher the probability that returns will be far below the expected return

* Two-Stock Portfolios:

* Can be combined to form a risklss portfolio if correlation (p)= -1.0

* Risk is not reduced at all if the two stocks have correlation (p)= +1.0

* In general, stocks have an approx.. correlation (p)= 0.35, so risk lowered but not eliminated

* What happens when adding stocks to a n average 1-stock portfolio?

* Standard deviation of the portfolio would decrease because the added stocks would not be perfectly correlated

* The expected portfolio rate of return would remain relatively constant

* Stand-alone risk, standard deviation of the portfolio, is reduced as the number of stocks in a portfolio increase

* Standard deviation of the portfolio falls very slowly after about 40 stocks

* Lower limit for standard deviation of a portfolio is about 20%= market risk

* Stand-alone risk= Market risk + Diversifiable risk

* Market risk is the part of a securities stand-alone risk that cannot be eliminated by diversification

* Firm-specific, or diversifiable, risk is the part of a security’s stand-alone risk that can be eliminated by diversification

* Market risk is measured by a stock’s beta coefficient:

* Beta is also defined as the slope of a regression line

* If b = 1.0, stock has average risk.

* If b > 1.0, stock is riskier than average.

* If b < 1.0, stock is less risky than average.

* Most stocks have betas from 0.5 to 1.5

* The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM)

* SML: ri = rRF + (RPM)bi

* RPM = (rM - rRF)

* Inflation increases the...