CMA® > CMA® Part 2 > B.1. Risk and Return Fundamentals > Flashcards

B.1. Risk and Return Fundamentals Flashcards

Understand financial risk types, CAPM, portfolio theory, and the relationship between risk and return. (57 cards)

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1
Q

What is financial risk?

A

Financial risk is risk connected to the financial health of a company, such as:

  • inability to access capital
  • lack of liquidity
  • customer concentration
  • foreign currency volatility
  • investment losses
  • compliance requirements and the risk of penalties for noncompliance.
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2
Q

What are the two main sources of returns on an investment?

A
  • Increase in the value of the investment
  • dividends or interest received while the investment is held
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3
Q

What is systematic risk?

A

Systematic risk, also known as market risk, is risk that affects all investments due to economywide factors. Systematic risk cannot be diversified away.

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4
Q

What are some types of systematic risk?

A
  • Market risk - risk inherent in an investment traded on a market and subject to market movements
  • Interest rate risk - risk of the value of an investment changing due to changes in the market rate of interest
  • Purchasing power risk - risk that the purchasing power of a fixed amount of money will decline due to inflation
  • Foreign exchange risk - risk that the value of a transaction denominated in a foreign currency will be negatively impacted by changes in the exchange rate during the holding period
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5
Q

What is unsystematic risk?

A

Unsystematic risk (also called company risk, specific risk, or nonmarket risk) is risk specific to a particular company or to the industry in which a company operates.

Unsystematic risk can be reduced through diversification.

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6
Q

What are some types of unsystematic risk?

A
  • Credit risk - the possibility that a borrower or counterparty will fail to meet their debt obligations according to agreed terms.
  • Liquidity, or marketability, risk - the possibility that an investment cannot be sold (converted into cash) for its market value.
  • Business risk - anything that threatens a company’s ability to achieve its financial goals.
  • Industry risk - risk that is specific to companies in a particular industry
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7
Q

Define:

Credit risk

A

The possibility that a borrower or counterparty will fail to meet their debt obligations according to agreed terms.

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8
Q

What is liquidity risk?

A

Also called marketability risk, is the possibility that an investment cannot be sold for its market value and must be significantly discounted to be sold.

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9
Q

What is the annual rate of return on an investment?

A

Annual Rate of Return = Return Received for One Year’s Investment / Average Balance of Amount Invested

The average balance is the average of the invested funds over the period during which the return used in the numerator was earned.

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10
Q

How is return annualized for investments held less than a year?

A

Multiply the partial year’s return by the factor needed to express it as an annual amount, such as multiplying by 2 for six months’ return or by 12 for one month’s return.

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11
Q

What is the relationship between risk and return in investing?

A

The higher the potential return, the higher the level of risk involved, and the lower the level of risk, the lower the potential return.

The best of both worlds, maximizing return while at the same time minimizing risk, is not an objective that is attainable in the world of investing.

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12
Q

What is the investors’ required rate of return?

A

The minimum rate of return that an average investor demands or expects to receive for holding a particular investment, given its level of risk. It represents the compensation investors require for taking on the risk of the investment and forgoing other investment opportunities.

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13
Q

What are the components of the investors’ required rate of return?

A
  1. The risk-free rate, the return on a virtually risk-free investment such as U.S. Treasury securities, which serves as the baseline return.
  2. A risk premium, the additional return demanded by investors to compensate for the specific risks of an investment beyond the risk-free rate.

There are two risk premiums:

  • Market risk premium
  • Specific security risk premium

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14
Q

What is a risk premium?

A

The return over and above the risk-free rate demanded by investors to compensate for the specific risks of an investment.

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15
Q

What is the difference between the market risk premium and a specific security’s risk premium?

A
  • MARKET RISK PREMIUM - The risk of the market as a whole; the difference between the expected return on a portfolio of stocks that includes all stocks in the market and the risk-free rate.
  • SPECIFIC SECURITY’S RISK PREMIUM - The risk premium that investors require to purchase that specific security. Incorporates the risk of the market as a whole and a factor (beta) for the individual security’s volatility with respect to the market.
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16
Q

What is the market risk premium?

A

The additional return demanded by investors beyond the risk-free rate to compensate for the specific risks of investing in the market.

It is the difference between the expected return on a portfolio of stocks that includes all stocks in the market and the risk-free rate, or the rate of return on U.S. Treasury bills.

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17
Q

What is the risk premium for investing in a specific security?

A

It incorporates the risk of the market as a whole and a factor for the individual security’s volatility with respect to the market.

It is the market risk premium multiplied by the factor for the individual security’s volatility.

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18
Q

What is pure risk?

A

The chance that an unwanted and detrimental event will take place, with only two possible outcomes: loss or no loss.

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19
Q

What is speculative risk?

A

The variability of actual returns from expected returns, which may result in either a gain or a loss.

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20
Q

True or False:

Systematic risk can be diversified away.

A

False

Systematic risk cannot be diversified away. Systematic risk is risk that affects all investments due to economywide factors.

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21
Q

What is business risk?

A

The risk of variability in an individual company’s earnings before interest and taxes. A business risk is anything that threatens a company’s ability to achieve its financial goals.

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22
Q

What factors contribute to business risk?

A
  • Variability of demand for products or services
  • Variability of selling prices
  • Variability of input prices
  • Degree of operating leverage
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23
Q

What is the Capital Asset Pricing Model (CAPM) used for?

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A
  • Estimates the investors’ required rate of return on a security or a portfolio of securities, given the risk to the investment.
  • Determines the average rate of return required for a particular investment by all market participants.

The CAPM uses the systematic risk for the security as measured by the security’s beta, the risk-free rate, and the expected return for the market portfolio to estimate the investors’ required rate of return for the security.

24
Q

What is the theory behind the Capital Asset Pricing Model?

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A

Investors will price investments so that the expected return on a security will be equal to the risk-free rate plus a risk premium that is proportional to the security’s risk.

The Capital Asset Pricing Model focuses on systematic, or market, risk and the impact it has on the investors’ required rate of return and thus the value of a security. The CAPM helps to understand the relationship between systematic risk and expected return for a security.

25
What is a **security's beta** (β) and what does it measure, as used in the Capital Asset Pricing Model?
A security’s beta (β) is a measurement of the security’s systematic risk. “Beta,” the letter “β” in the Greek alphabet, measures how a security’s historical returns have compared to the returns of the market portfolio.
26
What does a **beta of 1.0** as used in the Capital Asset Pricing Model indicate about a security's risk?
That the security has historically had the same systematic risk as the market portfolio, with returns moving in the same direction and amount as the market's returns. ## Footnote The beta for the market portfolio is defined as 1.0.
27
What does a **beta greater than 1.0** as used in the Capital Asset Pricing Model signify?
It signifies that the security has historically been more volatile than the market portfolio. ## Footnote The security's returns have increased or decreased by a greater percentage than the market's returns.
28
What does a **beta between 0 and 1.0** as used in the Capital Asset Pricing Model indicate?
It indicates that the security has historically been less volatile than the market portfolio. ## Footnote The security's returns have moved in the same direction as the market's returns but with less extreme movements.
29
What does a **negative beta** as used in the Capital Asset Pricing Model mean for a security?
It means the security's returns have historically moved in the opposite direction of the market portfolio. ## Footnote Negative beta investments may act as hedges against market downturns but carry opportunity and inflation risks.
30
As used in the Capital Asset Pricing Model, what is the **market portfolio**?
For the CAPM, the “market,” or “market portfolio” means all available common stocks, weighted according to their total aggregate market values outstanding. ## Footnote A benchmark index like the S&P 500 is usually used as a proxy for the market portfolio.
31
What is the Capital Asset Pricing Model formula?
**R = RF + β (RM − RF)** ## Footnote Where: R = Investors' required rate of return RF = Risk-free rate of return β = Beta coefficient RM = Expected rate of return for the market portfolio
32
What is the expected return for the market portfolio (RM) in the CAPM?
A forward-looking rate representing the expected return on all available common stocks, weighted by their market values. ## Footnote Analysts often use the historical return on a benchmark index like the S&P 500 as a proxy for RM.
33
What does the Capital Asset Pricing Model (CAPM) use to determine the investors’ required rate of return for a security?
* A security’s systematic risk (its beta) * The expected rate of return for the market portfolio * The risk-free rate
34
What is the **market risk premium** in the CAPM?
The difference between the expected return for the market portfolio and the risk-free rate. Market Risk Premium = RM − RF.
35
How is the specific stock risk premium calculated in the CAPM?
By multiplying the market risk premium by the beta for the specific stock. Specific Stock Risk Premium = β (RM − RF).
36
What happens to a security's market price if its beta increases?
The investors’ required rate of return will increase, leading to a decrease in the stock’s intrinsic value and its market price.
37
What is the **Security Market Line**? | (SML)
The graphical representation of the Capital Asset Pricing Model, showing the predicted investors’ required rate of return for an average security in the market at each level of beta.
38
What does the slope of the Security Market Line represent?
The market risk premium (RM − RF).
39
What does it mean if a security's expected return lies **above** the Security Market Line?
The security is undervalued in the market. Its market price should correct (increase) until its expected return lies on the Security Market Line.
40
What does it mean if a security's expected return lies **below** the Security Market Line?
The security is overvalued in the market. Its market price should correct (decrease) until its expected return lies on the Security Market Line.
41
What is the impact of a change in the risk-free rate on the Security Market Line?
The *y*-intercept of the SML will change. If the risk-free rate increases, the *y*-intercept will increase, moving the line upward.
42
How does a change in investors’ risk aversion affect the Security Market Line?
The slope of the SML will change. ## Footnote If investors become more risk averse, the line becomes steeper because investors require a higher rate of return for the same amount of risk (as identified by the various betas on the graph of the Security Market Line).
43
What is portfolio theory?
An investment philosophy that seeks to construct an optimal portfolio of securities according to an individual investor’s preferences with respect to risk and return.
44
What is the key to constructing a portfolio according to portfolio theory?
Diversification ## Footnote Diversification in investing is the practice of investing in a variety of securities so that a loss affecting one of the securities will have minimal effect on the whole portfolio.
45
What type of risk can be minimized through diversification in a portfolio?
Specific risk | (also called unsystematic or nonmarket risk)
46
What is the goal of asset allocation in portfolio management?
To achieve the best risk/return tradeoff possible by selecting a mix of assets.
47
What is a "fully diversified" or "efficient" portfolio?
One that provides the highest possible rate of return for a particular level of unsystematic risk or the lowest possible level of unsystematic risk for a particular rate of return.
48
Can diversification reduce systematic risk?
No ## Footnote Systematic risk is unavoidable and cannot be reduced through diversification.
49
# Define: Correlation
The tendency for two values or variables to change together, in either the same or the opposite way. ## Footnote Two variables that are **positively correlated** have historically increased at the same time and decreased at the same time. If two variables are **negatively correlated**, historically when one has increased, the other has decreased, and vice versa.
50
What is the **coefficient of correlation (r)** in portfolio theory?
The coefficient of correlation is a numerical measure that expresses both the direction and the strength of the linear association between two investments' returns, ranging from −1 to +1. ## Footnote In portfolio theory, the coefficient of correlation can be used to determine how closely two investments' returns have historically moved in relation to one another.
51
What does a correlation coefficient of +1 indicate?
Perfect, positive correlation where the returns of two securities have historically exactly matched each other.
52
What does a correlation coefficient of 0 indicate?
There has historically been no relationship between the returns of the two securities.
53
What does a correlation coefficient of -1 indicate?
Perfect, negative correlation where the returns of two securities have historically been perfectly opposite each other.
54
How can the coefficient of correlation be used in portfolio diversification?
To identify securities that **do not** have a highly positive correlation to each other (that is, security pairs with a low or negative value for their correlation coefficient) to effectively diversify a portfolio.
55
What inputs are needed for a quadratic computer program to find efficient portfolios?
* Expected return for each stock * Standard deviation of each stock * Correlation coefficient between each pair of stocks
56
What type of risk remains in a properly diversified portfolio?
Systematic risk | (market risk)
57
What is the measure of a portfolio's systematic risk, and how is it calculated?
* The average beta of the portfolio. * It is calculated as the weighted average of the individual securities' betas, where the weights are the proportion of each security's market value relative to the total market value of the portfolio.
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