Capital Markets And The Pricing Of Risk Chap 10 Flashcards
What is a common risk?
A perfectly correlated risk
What is an independent risk?
Risks that bear no relation to each other. If risks are independent, then knowing the outcome of one provides no information about the other. Independent risks are always uncorrelated, but the reverse need not be true
What is diversification?
The averaging of independent risks in a large portfolio
What are the two risks?
Systematic risk and Firm-specific risk
Systematic risk
The risk inherent in the whole market or part of the market
It is also called un diversifiable risk, market risk or volatility.
It is unpredictable and impossible to avoid
Firm specific, idiosyncratic, unique or diversiable risk
It is fluctuations of a stock’s return that are due to firm specific news are independent risks unrelated across stocks
How to measure the systematic risk of stock
We must determine how much of the variability of its return is due to systematic, market wide risks versus their diversifiable, firm specific risks
Efficient portfolio
It is a portfolio that contains only systematic risk. Efficient Portfolio cannot be diversified further. There is no way to reduce the volatility odd the portfolio without lowering its expected return. When risk-free borrowing and lending is available, the efficient portfolio is the tangent portfolio, the portfolio with the highest sharpe ratio in the economy.
Market portfolio
It is a value weighted portfolio of all shares of all stocks and securities in the market
Beta of a security
The better of a security is the expected % change in its return, given a 1% change in the return of the market portfolio
Market risk premium
The market a risk premium equals the difference between the market portfolio’s expected return and the risk free interest rate
Market risk premium= E[Rmkt] - rf
Estimating the cost of capital of an investment from its beta
rf= risk - free interest rate + betai x market risk premium
= rf + betai x ( E x [Rmkt] - rf)
Capital Asset Pricing Model (CAPM)
CAPM is in equilibrium model of the relationship between risk and return that characterises a securitie’s expected return based on its beta with the market portfolio.
