Capital Markets and the Pricing of Risk Flashcards
What is excess return?
The difference between the average return for an investment and the average return of risk free Treasury Bills
What does excess return measure?
The risk premium investors earned for bearing the risk of the investment
What are the two types of risk?
-Common Risk
-Independent Risk
What is common risk?
Perfectly correlated risk
What is independent risk?
Uncorrelated risk
What is diversification?
The averaging out of independent risks in a large portfolio
What is the relationship between diversification and independent and common risks?
-Independent risks are diversified in a large portfolio
-Common risks are not diversified in a large portfolio
What is a perfectly diversified portfolio and what does it represent?
-A portfolio where all the firm-specific risk has been diversified away
-Represents the market risk
What is the risk premium for a diversifiable risk?
0
What is the risk premium of a security determined by?
Systematic risk, the risk premium does not depend on diversifiable risk
How do you measure the systematic risk?
- How much return changes on average for each 1% change in security rates
-Must be an efficient portfolio (market portfolio)
What is the beta of a security?
The expected % change in return given a 1% change in return of the market portfolio
What is the market risk premium?
-The risk premium investors can earn by holding market risk
-Difference between the market portfolio’s expected return and the risk-free interest rate
What is the equation for the market risk premiun?
E[RMkt] -rf
What is the equation for CAPM?
rI=rf+ beta(E[Rmkt]-rf)
