Q Search this course Ch 06: Assignment - Risk and Return 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 New York 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. 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 the 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 return, and the likelihood of receiving it, or the investment's BARBARA: Let's begin with the way that risk can-or should be analyzed, Izzy, what is investment risk, and how should it be evaluated? IZZY: An investment's risk, or the probability that it generates a return that is its expected return, can be considered from two perspectives: that of stet, or a single-asset portfolio, and that of a multiple-asset portfolio The risk of a single asset is best measured by the of the asset's possible outcomes, while the risk of an asset in a multiple-asset portfolio is best measured by its BARBARA: Now I seem to recall that there are two major types of risk affecting a security Guctam sind BARBARA: Now, I seem to recall that there are two major types of risk affecting a security systematic and unsystematic risk. What is the difference between them, and is there a way to reduce your exposure to them? IZZY: Those are fantastic questions! Systematic risk, also called or market risk, results from phenomena that affect the majority of firms and securities. Since the events or circumstances that give rise to market risk affect most firms, it possible to diversify away this type of risk. Unsystematic, or company-specific, risk, on the other hand, is because it results from events and phenomena that are unique to a particular individual firm. Examples of these events or phenomena include, but are not limited to, earthquakes and tornados, labor unrest and strikes, and lawsuits or marketing campaigns. As these occurrences are , an investor's unsystematic risk can be diversified away by the number of securities held in the investor's portfolio The reduced riskiness of the market portfolio is reinforced by noting that the standard deviation of the average single-stock portfolio is 35%, whereas the standard deviation of the market portfolio, which is assumed to contain approximately stocks, is 20%. Therefore, the addition of more and more randomly selected stocks to the portfolio its riskiness. BARBARA: That makes sense. So what does this mean for the returns earned on an investment? IZZY: In short, it means that a rational investor can only expect to be compensated for his or her exposure to risk. He or she will not be compensated for the eliminated by increasing the size of his or her portfolio risk that could be BARBARA: So, the market will not compensate me for not doing what a rational investor could-and should-do. Is that right? IZZY: That is absolutely correct. The fact that you, as an investor, do not choose to act rationally be compensated. a Search this cc Ch 06: Assignment - Risk and Return BARBARA: Izzy, 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? 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 discussed today and several related concepts. It is intended to reinforce some of the important risk-and-return-related concepts. Have fun, and I'll see you next week! 1. Which of the following statements is correct? Check all that apply. The practice of diversification can effectively reduce an investor's company-specific risk. A investor's exposure to market risk can be diversified away by holding approximately 40 randomly-selected securities in an investor's portfolio. Possible sources of market or non-diversifiable risk include inflation and commodity price changes, changes in currency exchange rates, and fluctuations in interest rates. 2. The phenomena and behaviors discussed above are based on the assumption that the majority of investors are risk averse. According to the concept of risk aversion, Check all that apply. An investor will assess the rate of return offered by a security, and then determine the corresponding riskiness of the security. An investor will assess the riskiness of a security, and then determine his or her appropriate rate of return. 3. Which statement is correct? The addition of an asset to a portfolio, when the correlation coefficient between the asset's and portfolio's returns isol LIncrease the riskiness of the pastfalia A investor's exposure to market risk can be diversified away by holding approximately 40 randomly-selected securities in an investor's portfolio. Possible sources of market or non-diversifiable risk include inflation and commodity price changes, changes in currency exchange rates, and fluctuations in interest rates. 2. The phenomena and behaviors discussed above are based on the assumption that the majority of Investors are risk averse. According to the concept of risk aversion, Check all that apply. An investor will assess the rate of return offered by a security, and then determine the corresponding riskiness of the security. An investor will assess the riskiness of a security, and then determine his or her appropriate rate of return. 3. Which statement is correct? The addition of an asset to a portfolio, when the correlation coefficient between the assets and portfolio's returns is -1, will increase the riskiness of the portfolio. The addition of an asset to a portfolio, when the correlation coefficient between the assets and portfolio's returns is +1, will reduce the riskiness of the portfolio. It is theoretically impossible to create a portfolio that offers a positive return and a standard deviation of zero. It is theoretically possible to create a portfolio that offers a positive return and whose standard deviation is zero