ch 11 corporate finance

risk & return

what is expected return?

the return on a risky asset expected in the future

what is the risk premium?

the difference between the expected return on a risky investment, E(Ri), and the return on a risk free investment, Rf

what are the steps to calculating the variance and standard deviation?

1. first determine the squared deviations from the expected returns

2. next multiply each possible squared deviation by its probability

3. add these two = variance

4. the std dev is the sq root of the variance

what are portfolios?

a group of more than 1 asset such as stocks & bonds held by an investor

what are portfolio weights?

the most common way of expressing is to list the percentages of the total portfolios value that are invested in each portfolio asset

what is the total return?

expected return + unexpected return

what is a surprise?

the difference between the actual result and the forecast

what is an announcement?

expected part + surprise

what us systematic risk?

a risk that influences a large # of assets (aka market risk)

what is unsystematic risk?

a risk that effects, at most, a small # of assets (aka unique or asset specific risk)

what is risk return (R)?

R= E(R) expected return + (m) systematic risk + (e) unsystematic risk

t/f? the std dev declines as the # of securities is increased

TRUE

t/f? some of the riskiness associated with individual assets can be eliminated by forming portfolios

TRUE

what is diversification?

the process of spreading an investment across many assets will eliminate some of the risks

which type of risk is essentially eliminated by diversification?

unsystematic risk

which type of risk doesn’t go away? It is nondiversifiable

systematic risk

what is the systematic risk principle?

the expected return on a risky asset depends only on that assets systematic risk

what does the beta coefficient represent?

the amount of systematic risk present in a particular risky asset relative to that in an avg risky asset

an average asset has a beta of what relative to itself?

1.0

a risk free asset has a beta of what?

ZERO

what is the risk to reward ratio?

slope = E(Ra) - Rf divided by Beta(a)

• says the % of risk premium per unit of systematic risk

what is the fundamental relationship?

the reward to risk ratio must be the same for all of the assets in the market

what is the security market line?

a positively sloped straight line displaying the relationship between expected return & beta

representative of all of the assets in the market

• must have avg systematic risk

• has a beta of 1.0

what does the capital asset pricing model show?

shows the expected return for a particular asset depending on 3 things:

1. the pure time value of money

2. the reward for bearing systematic risk

3. the amount of systematic risk

what is the cost of capital?

the appropriate discount rate on a new project is the minimum an investment must offer to be attractive

• internal rate of return