Risk & Return Analysis Flashcards

What does standard deviation measure in a portfolio?

Answer: Volatility of returns

In a portfolio context, standard deviation is a statistical measure that quantifies the dispersion of returns around the average return. It is a widely used indicator of total risk, specifically measuring the volatility of the portfolio's returns. A higher standard deviation implies greater fluctuation in returns and thus higher risk.

Which of the following is an example of systematic risk?

Answer: Interest rate hike

Systematic risk, also known as market risk, is inherent to the entire market or a market segment and cannot be diversified away. An interest rate hike is a macroeconomic event that affects all companies and investments, making it a classic example of systematic risk. Company-specific issues like bankruptcy or product recall are examples of unsystematic risk.

Which metric evaluates a portfolio’s return per unit of total risk?

Answer: Sharpe Ratio

The Sharpe Ratio measures a portfolio's excess return (return above the risk-free rate) per unit of total risk, where total risk is represented by the portfolio's standard deviation. It helps investors understand how much additional return they are receiving for the extra volatility they are taking on. A higher Sharpe Ratio indicates a better risk-adjusted return.

What does alpha measure in performance evaluation?

Answer: Excess return relative to benchmark

Alpha is a measure of a portfolio's performance relative to a benchmark index, after accounting for the risk taken. It represents the "excess return" generated by the portfolio manager's skill, independent of market movements. A positive alpha indicates that the portfolio has outperformed its benchmark, while a negative alpha suggests underperformance.

Which type of risk can be reduced through diversification?

Answer: Unsystematic risk

Unsystematic risk, also known as specific risk or idiosyncratic risk, is the risk associated with a particular company or industry. This type of risk can be significantly reduced or even eliminated through diversification, by investing in a variety of assets across different sectors and geographies. Systematic risk, however, cannot be diversified away.

What does the Treynor Ratio use to measure risk?

Answer: Beta

The Treynor Ratio is a risk-adjusted performance measure that uses beta as its measure of risk. It calculates the excess return (portfolio return minus the risk-free rate) per unit of systematic risk (beta). Unlike the Sharpe Ratio, which uses total risk (standard deviation), the Treynor Ratio focuses specifically on systematic risk, making it suitable for diversified portfolios.