1. Basic concepts - Risk and return

Professor Isadore (Izzy) Invest-a-Lot retired two years ago from Exceptional College, a small liberal arts college in North Carolina after teaching corporate finance and investment theory for 35 years. Yesterday, Izzy appear on EC LIVE, a television show produced for the students, faculty and staff on the EU campus and the local communities. Betty Bigsmile is the host of EC LIVE, and one of Professor Izzys former students.

The following is a transcript of the interview. Unfortunately the software that transcribes the interview into written form failed to understand several words and phrases used in the interview. To complete the transcript and demonstrate your knowledge of the risks and returns of investing, please select the best answer from each dropdown menu.

BETTY: Good morning, Professor Invest-a-Lot. Id like to welcome you to EC LIVE, and thank you for coming in today to offer us insights into the basics of investing. I remember your course well, and while my grades didnt always reflect great success, I was always very interested in the material and the possibility of using the concepts and techniques when the opportunities arose.

IZZY: Good morning, Betty, and please call me, Izzy. Thank you for the invitation to discuss one of the important fundamentals to sound investing: an appreciation of the relationship between the objective or outcome of your investment, that is its ?? , and the likelihood of receiving it, or the investments.

-RISK

-RETURN

BETTY: Lets begin with a generalization regarding the financial markets. How are people buying and selling investments in the financial markets generally assumed to react to risk? And, how do the markets define risk?

IZZY: Risk is best thought of as the potential for variability in the investments outcomes. This means that if an investment has the potential to provide only one possible outcome or return, then it is ??

-RISK FREE

-RISKY

, while if there is more than one possible return or result, then the asset should be considered ???

-RISKY

-RISK FREE

. This is why securities sold by the U.S. Treasury have historically been considered to be the ??

-SAFEST

-MOST RISKY

securities in the world; because except in the event of the failure of the U.S. government, any investor holding a Treasury security would receive the securitys face value upon its maturity.

Most investors have an expected outcome associated with an investment, and risk refers to the potential for receiving an outcome or return that is greater or less than his or her expected return. It is not surprising that investors ??

-RESENT

-DONT MIND

receiving investment returns that exceed their expected return, but they tend to respond differently if the investment can generate a lower return. This potential for???

-A FAVORABLE

-AN UNFAVORABLE

outcome is the risk on which most investors focus.

In general, the majority of investors, or those buying and selling securities, are assumed to be ???

-RISK SEEKING

-RISK NEUTRAL

-RISK AVERSE

. This does not mean that they wont purchase or sell risky securities or projects, it simply means that they ???

-MUST

-DO NOT NEED TO

be compensated with a risk premium or additional return for taking on projects or securities exhibiting additional risk.

BETTY: So investors require a given amount of return for investing in a risk-free investment, and then require an additional risk premium if they invest in projects or securities that exhibit risk? Is that correct?

IZZY: Thats absolutely correct! And the magnitude of the risk premium will??

-DECREASE

-NOT CHANGE

-INCREASE

- as the amount of risk exhibited by the investment increases. So the riskiest investments require the risk premiums, and investments exhibiting relatively little risk require???

-GREATEST

-SMALLEST

risk premiums.

BETTY: OK, that makes sense, but how do you know how risky an investment is?

IZZY: It depends on how many investments you hold. If you hold only one investmentnot just one type, such as one house, one car, one savings account, but one of all possible investmentsthen you can measure the riskiness of that investment by calculating the???

-BETA

-STANDARD DEVIATION

-CORRELATION

of the investments possible returns.

If youre holding a portfolio of assets, on the other hand, then the risk that is of greater interest is the??

-INDIVIDUAL ASSET'S

PORTFOLIOS

riskiness, and how the addition of a new security or asset would affect the overall riskiness of the portfolio. This brings us to a related concept: the advantages and disadvantages of ???

-DIVERSIFICATION

-CONSOLIDATION

-DIVERGENCE

BETTY: This is related to the notion of not putting all of your eggs in one basket, isnt it? Doesnt it mean just holding a bunch of securities rather than only one or two? That way if the value of one stock goes down, its loss will be offset by the gains exhibited by the other securities in the portfolio. Right?

IZZY: Not exactly. Effective diversification requires knowledge of the extent to which the returns of an asset exhibit the same changes, increases or decreases over time, as the returns of another asset or group of assets. Notice that it is not the magnitude of return that is important in this case, but the degree to which their movements are synchronized over time. This tendency to move together is measured by the assets ??

-COEFFICIENT OF VARIATION

-CORRELATION COEFFICIENT

-COVARIATION COEFFICIENT

, and assets that are generate returns that exhibit the identical pattern over time. In contrast, assets that are ??

-PERFECTLY NEG CORRELATED

-PERFECTLY POSITIVELY CORRELATED

generate returns that exhibit the exactly opposite pattern.

Another way of thinking about the risk-reduction benefits of diversification is to focus on the standard deviations of the assets. If the standard deviation of the returns of an asset being added to a portfolio is??

-LESS

-GREATER

than the standard deviation of the portfolios return, then the riskiness of the portfolio will increase, rather than decrease, which is contrary to the goal of diversification.

It should be noted, however, that during the period of 1968 to 1998, the correlation coefficient for most pairs of randomly selected U.S. companies was 0.28. This means that the addition of a randomly selected U.S. company to a portfolio of other U.S. corporations should ???

-ELIMINATE

-INCREASE

-REDUCE the riskiness of the portfolio.

BETTY: Izzy, this is fascinating stuff. Unfortunately our time is up, but Id like very much for you to come back next week to continue our discussion. Would that fit into your schedule?

IZZY: Of course, and Ill look forward to it! However, before I leave, Id like to ask you and the audience to take a pop quiz. It addresses the material discussed today and is intended to reinforce some of the important concepts. Have fun, and Ill see you next week!

1. As a risk averse investor, which of the following four otherwise identical investment would you prefer?

-Security W, which exhibits a standard deviation of 2% and offers an average return of 12%.

-Security Z, which exhibits a standard deviation of 2% and offers an average return of 8%.

-Security Y, which exhibits a standard deviation of 4% and offers an average return of 8%.

-Security X, which exhibits a standard deviation of 4% and offers an average return of 12%.

2. According to research in the area of behavioral finance, the average risk averse investor perceives his or her gains and losses differently; that is, the utility derived from a $1,000 gain is not equal to the disutility associated with a $1,000 loss. According to this research, risk averse investors dislike or fear losses more than they enjoy gains.

-True

-False

3. Two securities, A and B, are expected to be worth $100.00 in one year. Because A is riskier than B, the current price of A should be ??

-EQUAL TO

-HIGHER THAN

-LOWER THAN

the current price of B.