Attempts: Average: 122 1. Basic concepts-Risk and return Professor Isadore (Izzy) Invest-a-Lot retired two years ago from Exceptional College, a small lberal arts college in Okiahoma after teaching corporate finance and investment theory for 35 years. Yesterday, Izzy appear on EC LIVE, a television show produced for the students, facuity and staft on the Eu campus and the local communities. Barbara Bighair is the host of EC LIVE, and one of Professor Izzy's 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 he best answer from each dropdown menu. Barbara Good morning, Professor Invest-a-Lot. I'd 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 didn't 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, Barbara, 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 likelihood of receiving it, or the investment's. , and the Barbara Let's 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 investment's outcomes. This means that if an investment has the potential to provide only one possible outcome or return, then it is result, then the asset should be considered considered to be the while if there is more than one possible return or This is why securities sold by the U.S. Treasury have historically been securities in the world; because except in the event of the failure of the U.S. government, any tzzy Risk is best though: of as the potential for variability in the investment's outcomes. This means that if an investment has the , while if there is more than one possible return or potential to provice only one possible outcome or return, then it is result, then the asset should be considered cons dered to be the investor holding a Treasury security would receive the security's face value upon its maturity. This is why securities so'd by the U.S. Treasury have historically been securities in the world; because except in the event of the failure of the U.S. government, any 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 returns that exceed the r expected return, but they tend to respond differently if the investment can generate a lower return. This potential for receiving investment 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 that they won't purchase or sel risky securities or projects, it simply means that they premium or addtional return for taking on projects or securities exhibiting additional risk This does not mean be compensated with a risk Barbara So investors require a given amount of return for investing in a risk-free investment, and then require an additional risk premium ir they invest in projects or securities that exhibit risk? Is that correct? Izzy That's absolutely correcti And the magnitude of the risk premium will investment increases. So the riskiest investments require the risk premiums. as the amount of risk exhibited by the risk premiums, and investments exhibiting relatively lttle risk require Barbara 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 investment-not just one type, such as one house, one car, one savings account, but one of all possible investments-then you can measure the riskiness of that investment by calculating the of the investment's possible returns. E unra haldinn a nortfolia of assets, on the other hand, then the risk that is of greater interest is the savings account, but one of all possible investments-then you can measure the riskiness of that investment by calauiating the of the investment's possible returns. If you're holding a portfolio of assets, on the other hand, then the risk that is of greater interest is the riskiness, and how the addition of a new security or asset would affect the overal/ riskiness of the portfolio. This brings us to a re lated concept: the edvantages and disadvantages of Barbara This is re ated to the notion of not putting all of your eggs in one basket, isn't it? Doesn't 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 exactiy. 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 asset's exhibit the identical pattern over time. In contrast, assets that are the exactly opposite pattern , and assets that are generate returns that generate returns that exhibit Another way of thinking about the risk-reduction benefits of divers fication 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 return, then the riskiness of the portfolio will increase, rather than decrease, which is contrary to the goal of diversification. than the standard deviation of the portfolio's 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 portfollio of other U.S. corporations should the riskiness of the portfolio. Barbara 1zzy, this is fascinating stuff. Unfortunately our time is up, but I'd like very much for you to come back next week to continue our discussion. Would that fit into your schedule? It should be noted, however, that during the period of 1968 to 1998, the correlation avefficient for most pairs of randomly selected u.s. companies was 0.28. This means that the addition of a randomiy selected U.S. compary to a portfolio of other U.S. corporations should the riskiness of the portfolio. Izy, this is fascinating stul. Unfortunately our time is up, but I'd like very much for you to come back next week to continue our discussion. Would that fit into your schedule? Barbara Izzy Of course, and I'll look forward to it However, before I leave, I'd like to ask you and the audience to take a pop quiz. It addresses the material disaussed today and is intended to reinforce some of the important concepts. Have fun, and 'll see you next weeki 1. Which of the following statements is correct? O The use of a security's historical standard deviation to estimate its future riskiness is a theoretically sound financial practice. O The fact that an investment generates a negative return implies that the investor has badly selected or managed their investments. O The use of a security's historical prices and returns to predict its estimated future return is theoretically sound. O An investment exhibiting a greater amount of risk will always return a higher actual return. 2. In general, it is reasonable to expect that holding a portfolio consisting of both international and domestic assets, rather than domestic stocks alone, will provide greater risk-reduction benefits due to which of the following factors? The differing economic, regulatory, and political systems expose domestic and international securities to different, and potentially offsetting sources and amounts of market risks. While the domestic and foreign companies share common sources of diversifiable risk, the differences ir market risk can still cause their patterns of returns to differ sufficiently to offer small risk-reduction benefits O The differing economic, regulatory, and political systems expose domestic and international securities to different, and potentially offsetting, sources and amounts of diversifiable and market risks. This can cause the securities to generate independent or offsetting patterns of returns. 3. Two securities, A and 8, are expected to be worth $100.00 in one year. Because A is riskier than B, the current price of A should be the current price of B