Download FRL 301 Chapter 13 Blogs Exam: Systematic and Unsystematic Risk, Diversification, and CAPM and more Exams Advanced Education in PDF only on Docsity!
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Systematic risk and example - ANSWER Systematic risk, also known as market risk, is a risk that effects many different assets in the market, such as the announcement of a new minimum wage rates which influences the United States economy.
Unsystematic Risk and Example - ANSWER unsystematic risks are risks that generally only influence a specific segment much like how an outbreak of e. coli in lettuce would impact the food industry.
Total Risk - ANSWER Total risk is the sum of both systematic and unsystematic risks when making a financial decision
Principle of Investment Diversification - ANSWER means that spreading an investment across a number of assets will eliminate some, but not all, of the risks. This principal tells us that Unsystematic Risk can be eliminated by diversification
Is investment diversification a good thing? - ANSWER Diversification is always good. Without it, you expose yourself to unsystematic risk, and the marketplace doesn't reward you for that exposure.
How is total risk measured? - ANSWER Total risk is measured by the standard deviation an investment's return, which is the sum of systematic risk and unsystematic risk.
How is systematic risk measured - ANSWER Systematic risk is measured by the beta coefficient, which shows how much risk a particular asset has relative to an average risky asset.
What does the beta coefficient of a stock tell us about that stock? ANSWER The beta coefficient essentially tells us what % a stock will have of a risk for a swing in prices in comparison to the risk the market has.
The Coefficient is based on a percentage scale : Ex. 1.0 = 100% Market Risk. 0.5 = 50% of Market. 1.5 = 150% of Market.
How can a stock's beta be used to calculate the risk premium for that stock? ANSWER Beta is applied in CAPM, a model that calculates the expected return of an asset using its beta and expected market returns You can also find the risk premium by multiplying the stock beta and the market risk premium The difference between returns of the market and risk-free rate.
Why must all assets in the market have the same reward-to-risk ratio? ANSWER If you plot expected returns vs. beta (systematic risk), all stocks will plot on the same line if they are correctly priced.
If one stock offers a better reward to risk ratio than another, everyone would buy that stock and no one would buy the stock with the lower reward to risk ratio. The two stocks' prices would adjust, due to supply and demand, until an equilibrium is reached where the two stocks have the same reward to risk ratio. This example can be expanded to all assets in the marketplace.
If at a given point in time, a stock has a reward-to-risk ratio larger than the slope of the Security Market Line (SML), is that stock over-valued, under-valued or fairly priced? - ANSWER The stock would be considered undervalued and the price of the stock price would rise until it met with the SML (security market line).
Explain why. What will happen to the price of that stock? - ANSWER This happens because all stock needs to line up on the SML so if a stock is below the line then the price is over-valued and the stock price needs to lower and if the stock is above the line the stock price would rise.
According to the Capital Asset Pricing Model (CAPM), which of the following determines the amount of reward an investor receives for bearing the risk associated with an individual security? - ANSWER According to the CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the market risk premium and the amount of systematic risk (that is referred as Beta) inherent in the security.
