IA - 10/27 & 29

What does beta measure?

A stock’s sensitivity to movements in the overall market

Why is beta the relevant risk measure for diversified investors?

Because unsystematic risk is diversified away

How do you interpret a beta greater than one?

The stock amplifies market movements and has more systematic risk

How do you interpret a beta less than one?

The stock moves less than the market and has less systematic risk

What does a beta of zero imply?

The asset has no exposure to market risk

What is the market risk premium?

The extra return investors demand for bearing market risk

What does CAPM explain conceptually?

The tradeoff between expected return and systematic risk

Under CAPM what kind of risk is rewarded?

Systematic risk only

What happens to expected return as beta increases?

Expected return increases

What does alpha represent conceptually?

Return not explained by exposure to market risk

What does a positive alpha indicate?

Outperformance relative to what CAPM predicts

What does a negative alpha indicate?

Underperformance relative to what CAPM predicts

What is the Sharpe ratio used to measure?

Return per unit of total risk

When should the Sharpe ratio be used?

When portfolios are well diversified

What type of risk does the Sharpe ratio use?

Total volatility

What is the Treynor ratio used to measure?

Return per unit of systematic risk

When should the Treynor ratio be used?

When portfolios are not fully diversified

What type of risk does the Treynor ratio use?

Systematic risk

Key difference between Sharpe and Treynor

Sharpe uses total risk Treynor uses beta

What is Jensen’s alpha used for?

Measuring manager skill relative to CAPM

What does holding period return measure?

The total return earned over an investment’s holding period

How does volatility scale with time?

It scales with the square root of time

What does alpha measure that beta does not?

Performance unrelated to market movements

Why can a portfolio have a low beta but still be risky?

Because it may have significant unsystematic risk

Why does CAPM ignore unsystematic risk?

Because it can be diversified away at no cost

Why might Sharpe and Treynor rank portfolios differently?

Because they use different definitions of risk

When would Jensen’s alpha be preferred over Sharpe or Treynor?

When evaluating performance relative to CAPM

What does negative skewness mean for investors?

Losses tend to be larger or more frequent than gains

Why does kurtosis matter even if average returns look normal?

Extreme outcomes occur more often than expected

Why do fat tails matter for risk management?

They increase the probability of extreme losses