Ch 13- Return Risk and Security Flashcards
in the assignment, it is very likely that even if you choose one individual stocks, you will moer likely get higher reward if you BLEND stocks
instead of pickoing one best stock you will be better off picking a blend
what is the measure of systematic risk
BETA
What are expected returns
the sum of the probabilities of an outcome
ex:
if you get 100 on tails or -100 on heads
you do it like this
100(0.5)+(-100)(0.5)=0
EXPECTED VALUE IS 0
What does state of nature mean
the different outcomes that you can have!! (all must sum to 1)
Ri , Pi, piRi meaning, E(R)
WHAT IS THE GOAL
Ri = return of i
Pi = probability of i
piRi= probability of getting return (multiply)
E(R): Expected return- sum all of probability of getting returns
HIGHEST EXPECTED RETURN
What is the variance and standard deviation
measurnig the volatility of returns
YOu can use unequal prob for the entire range of possibilites
Formula for variance
Sum of all probabilitites(return-expected return))^2
How do you calcc expected returns and variances in your calculator
- stat, L1 , put in your probabilitis as % (30%=0.3)
- stat, L2, put in your returmss as % (2%=0.02)
- stat, calc,1- var stats, list=l2, freqlist=l1
- you will get sigmax (square it to get var) [DO NOT USE THE Sx IT WILL BE 0!!!!!!! we want SIGMAx because it is the population deviation
]
What is a portfolio
collection of assets
how do you measure the risk return tradeoff for a protfolio
EXPECTED RETURN!!! AND STANDARD DEVIATION (just like w individual assets)
How do you figure out the expected return of a portfolio
- Get the weighted amounts for each portfolio
- Multiply weight OF EACH PORTFOLIO * return IN STATE OF NATURE i and sum all of them
- You will get expected return of the portfolio
E(Rp) = Sum(Wi)(ri)
How to do portfolio variance questions that are really complicated
- Note the states of nature (and what are the probabilites associated with them)
- declare the stocks and their porbabilities in each state of nature
- declare the % invested in each stock
- for portfolio return
(state of naturei)(Stock1 return)+(State of naturei)(stock 2 return)
DO THIS FOR ALL STATES OF NATURE
- Get the weighted average of the returns (State of nature i )(portfolio return) + (State of nature ii )(Portfolio return)
- To get variance
(State of nature)(Portfolio return - weighted avergage)^2
DO THIS FOR ALL STATES OF NATURE
- Sum all the individual variances you got together!!!
Alternative way to calculatee proftolio variance
(Weight of A)^2 x (Variance of A) + (Weight of b)^2 x (Variance of b) + (2WaWb x Corr AB)
CorrAB is the correlation coefficient
what does perfect correlation (1) mean
when we can tell where one is by looking at where the other is (THIS IS WHEN THEY MOVE IN THE SAME DIRECITON)
what is the goal in investing
getting negative correlation (of a return with no risk attached!!!)
Does not have to be a lot of return but it can just be a loop
What is a feasible set?
this is the curve that shows all possible portfolio combos (we can go from U to L in class notes)
What is the efficient set?
the portion of the feasible set that has only the portfoflios w max return for an x amount of risk OR when minimum risk is accepted for given level of return
Basically if there is a curved point (or a point on the graph that does not point the vertical line test) choose the one with either max return or min reward
what is the MVP
the portfolio with the least variance (lowest possible risk FORGET RETURNS)
Realized returns are not always equal to expected returns
!!
When we see a round cloud between realized and expected what oes it mean
0 correlation
What are efficient markets the result of?
investors trading on unexpected portion of announcements
In efficient markets
you want to be able to trade instantaneously!!!! reactions will happen really quickly
Systematic risk
affect lots of assets
SYNONYM: NON-DIVERSIFIABLE RISK, MARKET RISK
EX: LIKE COVID, GDP, INFLATION, INTEREST RATES (cost of monye)
unsystematic risk
affects a limited number of assets, affects a single industry
“Unique risk” or “Asset-specific risk”
total return
expected return + unexpected return
or
[[[[[[[[[[[[[ expected return + systematic return + unsystematic return ]]]]]]]]]]]]]]]
EXPECTED RETURN= What we THOUGHT we were getting going in
SYSTEMATIC RETURN= unexpected return due to the market (nothing to do with the company)
UNSYSTEMATIC RETURNS= good or bad due to the company or the company or industry (door blwoing off a boeing)
formual for unexpected return
systematic return + unssystematic return
basiacally diversifiable risk is risk we can mitigate by owning shares in different companies/ indsutries
As you buy more stocks you reduce the standard deviation
!!
Is diversifiable risk necesary?
no!
What is total risk = ?
systematic risk + unsystematic risk
(the dtandard deviation of returns is a measure of total risk)
What is the systematic risk principle
there is a reward for systematic risk, there is no reward for bearing risk uncessarily (unsystematic risk)
How do you measure systematic risk
we use the beta coefficient to measure!!
-a beta of 1 implies a asset haas the same systematic irks as the overall market
-low beta stocks still dont move around with the overall market
Id there are two stocks C & K
if C has a higher beta and K has a higher SD what does it mean?
what has more total risk, what has more systemeaitc risk, what are we paid more for owning?
C does really wel when the market is doing well, but when the market is dropping it is extremely bad
K does its own thing not associated with the market, it is driven by its own up and down not linked to the market as C is
K has more total risk, C has higher systematic risk, we get paid more for owning K
Formula for portfolio beta:
weighted avf of component betas (weight)(beta)+(weight2)(beta2)
When computing the expected return on a portfolio of stocks the portfolio weights are based on the:
market value of shares
if assets are above the risk reard line= buy them
if assets are below the risk reqrd line=sell them
if the market is efficient, all assets should be on the green line (risk reward line)
these assets have the same reqard to risk ratio
WHat is the SML
security maket line represents market equilibrium
the slope of the SML is the reward to risk ratio
(E(Rm)-Rf)/BetaM (MARKET RISK PREMIUM)
What defines the raltionship between risk and return
capital assset pricing model (CAPM)
E(Ra)= Rf + BetaA(E(Rm)-Rf)
exp return on asset= risk free rate + beta of asset(exp return on market)- Risk free rate)
What are factors affecting expected return
- pure time value of money- measured by the risk free rate
- reward for bearing systematic risk
what is another name for the time value of money
risk free rate
If the risk free rate is 4.5% and the market risk premium is 8.5% what is the expecterd rm
13%
