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Chapter Review


1.What is the fundamental motivation behind portfolio theory? That is, what are people trying to achieve by investing in portfolios of stocks rather than in a few individual stocks or in debt? What observations prompted this view?

2. What is the general (in words) relationship between risk and return?

3. Define and discuss (words only, no equations) the concepts of expected return and required return.

4. Give a verbal definition of “risk” that’s consistent with the way we use the word in everyday life. Discuss the weaknesses of that definition for financial theory.

5. Define risk aversion in words without reference to probability distributions. If people are risk averse, why are lotteries so popular? Why are trips to Las Vegas popular? (Hint: Think in terms of the size of the amount risked and entertainment value.)

6. The following definition applies to both investing and gambling: putting money at risk in the hope of earning more money. In spite of this similarity, society has very different moral views of the two activities.

  1. Develop an argument reconciling the differences and similarities between the two concepts. That is, why do people generally feel good about investing and bad about gambling? (Hint: Think of where the money goes and what part of a person’s income is used.)
  2. Discuss the difference between investing and gambling by referring to the probability distributions shown. Identify the representations of a total loss, a big win, and likely outcomes.

7. Why does it make sense to think of the return on a stock investment as a random variable? Does it make sense to think of the return on a bond investment that way? How about an investment in a savings account?

8. In everyday language, “risk” means the probability of something bad happening. “Risk” in finance, however, is defined as the standard deviation of the probability distribution of returns.

  1. Why do these definitions seem contradictory?
  2. Reconcile the two ideas.

9. Analyze the shape of the probability distribution for a high-risk stock versus that of a low-risk stock. (Hint: Think in terms of where the area under the curve lies.)

10. Describe risk in finance as up-and-down movement of return. Does this idea make sense in terms of the variance definition?