Risk

Risk and return questions

and practice problems

Risk and return part 1:

Questions

1. Suppose the standard deviation of the returns on the shares of stock at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these two stocks? Why?

2. The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is -0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want your portfolio to have the lowest possible risk, would you buy stock B or C?

3. What does the historical relation between volatility and return tell us about investors’ attitude toward risk?

4. What is the intuition behind using the average annual return as a measure of expected return?

5. What does it mean to be risk averse?

6. Describe how investing in more than one asset can reduce risk through diversification.

7. If you randomly select 10 stocks for a portfolio and 20 other stocks for a different portfolio, which portfolio is likely to have the lower standard deviation? Why?

8. What does correlation tell us?

9. Why isn’t the total risk of a portfolio simply equal to the weighted average of the risks of the securities in the portfolio?

10. In which of the following situations would you get the largest reduction in risk by spreading your portfolio across two stocks?

a. The stock returns vary with each other

b. The stock returns are independent

c. The stock returns vary against each other

Selected Answers

1. No

2. Stock C

7. The 20 stock portfolio

10. C.

Problems

1. Stocks A, B, and C have expected returns of 15%, 15% and 12%, respectively, while their standard deviations are 45%, 30%, and 30%, respectively. If you are considering the purchase of each of these stocks as the only holding...