NISM Series XV · Unit 12 of 15 · about 7% of the paper
Fundamentals of risk and return: NISM Series XV notes and practice questions
The portfolio theory behind research: expected return, volatility, correlation and CAPM.
What to know in Unit 12
- Risk measures.
- Correlation and diversification.
- CAPM and risk-adjusted performance.
Key terms, examples and exam traps
Expected return
Expected return is the probability-weighted average of possible returns of an investment.
Example. An asset has a 50% chance of 20% and a 50% chance of 0%, giving 10%.
Exam trap. This statement is false: Expected return is the highest possible return.
Variance and standard deviation
Variance measures the dispersion of returns around the mean; standard deviation is its square root and the common measure of volatility.
Example. A stock's returns swing widely around its average.
Exam trap. This statement is false: Standard deviation is the average return.
Correlation
Correlation measures how two assets move together, from −1 to +1; lower correlation gives greater diversification benefit.
Example. Two assets with correlation near zero reduce portfolio volatility when combined.
Exam trap. This statement is false: A correlation of +1 gives the best diversification.
Systematic risk and beta
Systematic risk is market-wide and measured by beta; it cannot be diversified away.
Example. A stock with beta 1.3 amplifies market moves.
Exam trap. This statement is false: Beta measures company-specific risk.
CAPM
The Capital Asset Pricing Model states that expected return equals the risk-free rate plus beta times the market risk premium.
Example. A stock's required return is built from risk-free rate and market risk premium.
Exam trap. This statement is false: CAPM says return depends on total risk.
Security market line
The security market line plots expected return against beta; securities above it are undervalued.
Example. A stock offering more return than CAPM predicts lies above the line.
Exam trap. This statement is false: The security market line plots return against standard deviation.
Sharpe ratio
The Sharpe ratio is excess return over the risk-free rate divided by standard deviation, measuring return per unit of total risk.
Example. A fund earns 14% with risk-free 6% and standard deviation 16%, giving 0.5.
Exam trap. This statement is false: The Sharpe ratio uses beta as the risk measure.
Treynor ratio
The Treynor ratio is excess return divided by beta, measuring return per unit of systematic risk.
Example. A portfolio's excess return is divided by its beta.
Exam trap. This statement is false: The Treynor ratio uses standard deviation.
Jensen's alpha
Jensen's alpha is the return in excess of the CAPM-predicted return, showing a manager's value addition.
Example. A fund earns 2% more than CAPM predicts.
Exam trap. This statement is false: A negative alpha indicates outperformance.
Efficient frontier
The efficient frontier is the set of portfolios offering the highest expected return for each level of risk.
Example. A set of optimal portfolios that cannot be improved on both return and risk.
Exam trap. This statement is false: Every portfolio lies on the efficient frontier.
Risk-free rate
The risk-free rate is the return on an investment with no default risk, such as the government security yield.
Example. A ten-year G-sec yield is used as the base rate.
Exam trap. This statement is false: The risk-free rate is the rate on corporate bonds.
Diversification benefit
Combining imperfectly correlated assets reduces portfolio risk without a proportional fall in return.
Example. Adding gold to an equity portfolio smooths overall volatility.
Exam trap. This statement is false: Diversification increases portfolio risk.
Downside risk
Downside risk measures the chance and size of losses below a target, as in semi-deviation or maximum drawdown.
Example. An investor tracks how far a fund fell from its peak.
Exam trap. This statement is false: Downside risk counts only positive returns.
Maximum drawdown
Maximum drawdown is the largest peak-to-trough fall in value over a period, showing the worst loss an investor would have faced.
Example. A fund fell 35% from its high before recovering.
Exam trap. This statement is false: Maximum drawdown is the highest gain.
6 practice questions
Read each question and choose your answer before opening the free mock, which shows the correct answer and the reason.
Q1. Which statement best describes “Sharpe ratio”?
- The debt-to-equity ratio is total debt divided by shareholders' equity and shows financial leverage.
- The Sharpe ratio is excess return over the risk-free rate divided by standard deviation, measuring return per unit of total risk.
- Fundamental analysis estimates a security's intrinsic value from economic, industry and company factors and compares it with market price.
- Sum-of-the-parts values each business unit separately and adds them, useful for conglomerates.
Q2. Which statement best describes “Downside risk”?
- Dow theory holds that markets move in primary, secondary and minor trends, and that averages must confirm each other.
- For cyclical firms, valuation based on peak or trough earnings misleads, so analysts use average or normalised earnings.
- Asset turnover is revenue divided by total assets and shows how efficiently assets generate sales.
- Downside risk measures the chance and size of losses below a target, as in semi-deviation or maximum drawdown.
Q3. Which statement best describes “Risk-free rate”?
- The risk-free rate is the return on an investment with no default risk, such as the government security yield.
- A candlestick shows open, high, low and close for a period, with the body showing the open-to-close range and wicks showing extremes.
- Crude oil prices are driven by OPEC+ decisions, global demand, inventories and geopolitical events.
- Interest coverage is EBIT divided by interest expense, showing how comfortably a company can pay interest.
Q4. Which statement best describes “Jensen's alpha”?
- Jensen's alpha is the return in excess of the CAPM-predicted return, showing a manager's value addition.
- The ex-dividend date is the date from which a share trades without the right to the declared dividend; buyers on or after it do not receive it.
- The Purchasing Managers' Index surveys business activity; a reading above 50 indicates expansion and below 50 contraction.
- A demerger splits a business into two or more entities, and shareholders receive shares in the new entity in a given ratio.
Q5. Which term is described here? The Treynor ratio is excess return divided by beta, measuring return per unit of systematic risk.
- Margin of safety
- Free cash flow to firm
- Treynor ratio
- Bonus issue
Q6. Which term is described here? Variance measures the dispersion of returns around the mean; standard deviation is its square root and the common measure of volatility.
- Net profit margin
- Triangle pattern
- Variance and standard deviation
- Correlation
Frequently asked questions
How much of NISM Series XV comes from Unit 12?
Unit 12 (Fundamentals of risk and return) usually carries about 7% of the questions. The whole exam has 100 questions and the pass mark is 60%.
What should I study in NISM Series XV Unit 12?
Risk measures. Correlation and diversification. CAPM and risk-adjusted performance.
Are these NISM Series XV practice questions free?
Yes. Take the full free mocks to see the correct answer and the reason for every question.
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