Question: Define the following terms, using graphs or equations to illustrate your answers where feasible. a. Risk in general; stand-alone risk; probability distribution and its relation
a. Risk in general; stand-alone risk; probability distribution and its relation to risk
b. Expected rate of return, r
c. Continuous probability distribution
d. Standard deviation, σ; variance, σ2; coefficient of variation, CV
e. Risk aversion; realized rate of return, r
f. Risk premium for Stock i, RPi; market risk premium, RPM
g. Capital Asset Pricing Model (CAPM)
h. Expected return on a portfolio, r
p; market portfolio
i. Correlation as a concept; correlation coefficient, ρ
j. Market risk; diversifiable risk; relevant risk
k. Beta coefficient, b; average stock’s beta
l. Security Market Line (SML); SML equation
m. Slope of SML and its relationship to risk aversion
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a Standalone risk is only a part of total risk and pertains to the risk an investor takes by holding only one asset Risk is the chance that some unfavorable event will occur For instance the risk of an asset is essentially the chance that the assets cash flows will be unfavorable or less than expected A probability distribution is a listing chart or graph of all possible outcomes such as expected rates of return with a probability assigned to each outcome When in graph form the tighter the probability distribution the less uncertain the outcome b The expected rate of return r is the expected value of a probability distribution of expected returns c A continuous probability distribution contains an infinite number of outcomes and is graphed from and d The standard deviation is a statistical measure of the variability of a set of observations The variance 2 of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation The coefficient of variation CV is equal to the standard deviation divided by the expected return it is a standardized risk measure which allows comparisons between investments having different expected returns and standard deviations e A risk averse investor dislikes risk and requires a higher rate of return as an inducement to buy riskier securities A realized return is the actual return an investor receives on their investment It can be quite different than their expected return f A risk premium is the difference between the rate of return on a riskfree asset and the expected return on Stock i which has higher risk The market risk premium is the difference between the expected return on the market and the riskfree rate g CAPM is a model based upon the proposition that any stocks required rate of return is equal to the risk free rate of return plus a risk premium reflecting only the risk remaining after diversification h The expected return on a portfolio r p is simply the weightedaverage expected return of the individual stocks in the portfolio with the weights being the fraction of total portfolio value invested in each stock The market portfolio is a portfolio consisting of all stocks i Correlation is the tendency of two variables to move together A correlation coefficient of 10 means that the two variables move up and down in perfect synchronization while a coefficient of 10 means the variables always move in opposite directions A correlation coefficient of zero suggests that the two variables are not related to one another that is they are independent j Market risk is that part of a securitys total risk that cannot be eliminated by diversification It is measured by the beta coefficient Diversifiable risk is also known as company specific risk that part of a securitys total risk associated with random events not affecting the market as a whole This risk can be eliminated by proper diversification The relevant risk of a ... View full answer
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