27 Lecture

1. Which of the following is NOT a characteristic of systematic risk? A) It cannot be diversified away. B) It affects the entire market or a broad segment of it. C) It is also known as market risk. D) It is unique to a particular company or industry.

Answer: D) It is unique to a particular company or industry.

2. Which of the following is a measure of a security's systematic risk? A) Alpha B) Beta C) R-squared D) Standard deviation

Answer: B) Beta

3. According to the Capital Asset Pricing Model (CAPM), the expected return on a security is equal to: A) the risk-free rate plus the market risk premium. B) the market return minus the risk-free rate. C) the security's beta times the market risk premium. D) the security's beta divided by the market risk premium.

Answer: A) the risk-free rate plus the market risk premium.

4. The risk-free rate of return is typically measured using: A) the return on Treasury bills. B) the return on common stocks. C) the return on corporate bonds. D) the return on preferred stock.

Answer: A) the return on Treasury bills.

5. The Security Market Line (SML) in the CAPM represents: A) the relationship between a security's expected return and its beta. B) the relationship between a security's expected return and its standard deviation. C) the relationship between a security's expected return and its alpha. D) the relationship between a security's expected return and the market return.

Answer: A) the relationship between a security's expected return and its beta.

6. The beta of a diversified portfolio is: A) the weighted average of the betas of the individual securities in the portfolio. B) always greater than 1. C) always less than 1. D) equal to the risk-free rate.

Answer: A) the weighted average of the betas of the individual securities in the portfolio.

7. Which of the following is a criticism of the CAPM? A) It assumes that investors are risk-averse. B) It assumes that investors have perfect information. C) It assumes that markets are efficient. D) It assumes that all investors have the same investment time horizon.

Answer: B) It assumes that investors have perfect information.

8. The Sharpe Ratio is a measure of: A) a security's systematic risk. B) a security's total risk. C) a security's excess return per unit of total risk. D) the relationship between a security's expected return and its beta.

Answer: C) a security's excess return per unit of total risk.

9. Which of the following is an example of unsystematic risk? A) A global pandemic causing a market-wide downturn. B) A company's CEO being indicted for fraud. C) A new competitor entering the market. D) A rise in interest rates causing bond prices to fall.

Answer: B) A company's CEO being indicted for fraud.

10. Which of the following is NOT a strategy for managing risk in a portfolio? A) Diversification B) Asset allocation C) Market timing D) Hedging

Answer: C) Market timing.

1. What is the difference between systematic and unsystematic risk? Answer: Systematic risk, also known as market risk, is the risk that affects the entire market or a broad segment of it, such as changes in interest rates, economic conditions, or geopolitical events. Unsystematic risk, on the other hand, is specific to a particular company or industry, such as a management scandal, product recall, or supply chain disruption.

2. What is the Capital Asset Pricing Model (CAPM) and how does it work? Answer: The CAPM is a financial model that describes the relationship between risk and expected return. It suggests that the expected return on a security is equal to the risk-free rate plus a premium for bearing market risk, which is determined by the security's beta. Beta is a measure of a security's systematic risk relative to the overall market. According to the CAPM, a security's expected return should be proportional to its beta, with higher beta securities having higher expected returns.

3. What are the assumptions of the CAPM? Answer: The CAPM makes several key assumptions, including that investors are rational and risk-averse, that markets are efficient and all investors have the same information, that there are no transaction costs, taxes or other frictions, and that investors have homogeneous expectations about the future.

4. What is portfolio theory and how does it relate to risk management? Answer: Portfolio theory is the study of how investors can construct portfolios of assets to optimize their expected return for a given level of risk. The theory emphasizes the importance of diversification, which can reduce unsystematic risk and increase returns through a combination of assets with different correlations. By constructing a portfolio of assets with different levels of risk and return, investors can manage their exposure to risk while potentially earning higher returns.

5. What is the Sharpe Ratio and how is it used in risk management? Answer: The Sharpe Ratio is a measure of risk-adjusted return that takes into account both the return and the risk of an investment. It is calculated by subtracting the risk-free rate from the portfolio or investment's return, and dividing by the portfolio or investment's standard deviation. The higher the Sharpe Ratio, the better the risk-adjusted return of the investment. The Sharpe Ratio can be used to compare the risk-adjusted returns of different investments or portfolios.

6. What is beta and how is it used in the CAPM? Answer: Beta is a measure of a security's systematic risk, or the risk that cannot be diversified away. It measures how much a security's returns move relative to the market as a whole. Beta is used in the CAPM to determine the expected return of a security, with higher beta securities expected to have higher returns.

7. What is diversification and how does it reduce risk? Answer: Diversification is the process of investing in a variety of assets that have different risk and return characteristics. By holding a diversified portfolio, an investor can reduce unsystematic risk, or the risk specific to a particular company or industry, because losses in one area can be offset by gains in another. Diversification can increase the overall return of a portfolio for a given level of risk.

8. What are the limitations of the CAPM? Answer: The CAPM has several limitations, including that it assumes perfect information and efficient markets, which may not always be the case. It also assumes that investors are rational and risk-averse, which may not always be true. In addition, the CAPM does not take into account other factors that may affect a security's returns, such as liquidity, size, or momentum.

9. What is the relationship between risk and return? Answer: In general, the higher the risk of an investment, the higher the potential return.

Risk and portfolio theory are essential components of modern finance. Portfolio theory is based on the idea that by diversifying one's investments, an investor can reduce risk without necessarily reducing returns. In other words, by investing in a variety of assets with different risk and return characteristics, an investor can create a portfolio that is more efficient than any single asset. The Capital Asset Pricing Model (CAPM) is a widely used financial model that attempts to quantify the relationship between risk and expected return. According to the CAPM, the expected return on a security is equal to the risk-free rate plus a premium for bearing market risk, which is determined by the security's beta. Beta is a measure of a security's systematic risk relative to the overall market. However, the CAPM has been subject to criticism over the years. One criticism is that it relies on a number of unrealistic assumptions, including the idea that markets are efficient and all investors have the same information. In addition, the CAPM does not take into account other factors that may affect a security's returns, such as liquidity, size, or momentum. Some critics have argued that the CAPM is too simplistic and cannot adequately capture the complex relationships between risk and return. Despite these criticisms, the CAPM remains an important tool for investors and financial professionals. It provides a useful framework for thinking about the relationship between risk and expected return, and it is widely used in practice for evaluating investment opportunities. Moreover, while the CAPM may have limitations, it is still a valuable starting point for developing more sophisticated models of risk and return. Overall, risk and portfolio theory, along with the CAPM, are critical components of modern finance that help investors manage risk and make informed investment decisions.