Chapter 13: Return, Risk, and the Security Market Line Flashcards
States of the economy
For example, suppose the economy booms. In this case, we think Stock L would have a 70% return. If the economy enters a recession, we think the return would be −20%.
Thus we have two states of the economy
Meaning there are only 2 possible situations
Expected return
Return on a risky asset expected in the future.
To find the expected return:
Take the :Probability of State of the Economy” number (say 0.5), and the “Security Returns if State Occurs” ( say -20% and 70%) and multiply each number to the 0.5.
E(Ru) = (0.50 x -20%) + (0.50 x 70%) = 25%
portfolio
Group of assets such as stocks and bonds held by an investor.
AKA investors hold more than one kind of stock
portfolio weights
Percentage of a portfolio’s total value in a particular asset.
Must always = 100% or 1
TABLE 13.6
Variance on an equally weighted portfolio of Stock L and Stock U STEPS
(1) State of Economy (shows the boom and the bust)
(2) Probability of State of Economy (Included in the question)
(3) Portfolio Return if State Occurs (Included in the question)
(4) Squared Deviation from Expected Return (Take info from step 3 and subtract expected return. Take this number and square it
(5) Product step (2) × step (4)
Correlation
which provides a measure on the extent to which the returns on two assets move together
- If correlation is positive, we say that Assets A and B are positively correlated
- If correlation = 0 than the are uncorrelated
If correlation = 1 or -1, it is perfectly positively correlated or perfectly negatively correlated
The return on any stock traded in a financial market is composed of two parts.
First, the normal or expected return from the stock is the part of the return that shareholders in the market predict or expect
The second part of the return on the stock is the uncertain or risky part
One way to write the return of a stock in the coming year
Total return = Expected return + Unexpected return
R = E(R) + U
innovation or the surprise
Lets say we predicted GNP to raise 0.5% but it actually raised 1.5%, this would be a surprise to us
Announcement =
Expected part + Surprise
The expected part of any announcement is the part of the information that the market uses to form the expectation, E(R), of the return on the stock
The surprise is the news that influences the unanticipated return on the stock
After all, if we always receive exactly what we expect, the investment is perfectly predictable and, by definition, _______
risk free
systematic risk
Also called market risk
A risk that influences a large number of assets
Made up of risk premium + Beta
Examples: GNP, interest rates, or inflation, are examples of systematic risks
unsystematic risk
Also called unique or asset-specific risks.
A risk that affects, at most, a small number of assets.
Example: the announcement of an oil strike by a company, Unanticipated lawsuits, industrial accidents, strikes
Announcement =
If a systematic and unsystematic risk exists
R = E(R) + Systematic portion + Unsystematic portion
This just breaks up ‘U’
principle of diversification
Principle stating that spreading an investment across a number of assets eliminates some, but not all, of the risk.
nondiversifiable risk
The minimum level of risk cannot be eliminated simply by diversifying
Final remarks for unsystematic risk
Unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk
Can systematic risk can be eliminated by diversification?
As a result, no matter how many assets we put into a portfolio, the systematic risk doesn’t go away. The terms systematic risk and nondiversifiable risk are used interchangeably.
systematic risk principle
Principle stating that the expected return on a risky asset depends only on that asset’s systematic risk.
beta coefficient
Amount of systematic risk present in a particular risky asset relative to an average risky asset.
Do you want a high BETA or a low BETA
an investor who buys stock in Bank of Nova Scotia, with a beta of 1.33, should expect to earn less, on average, than an investor who buys stock in Teck Resources Limited, with a beta of 2.94.
High = more risk but potential greater reward
A BETA larger than has greater systematic risk than an average asset
Portfolio Betas
When looking at the BETAs for two stocks you want to invest in to create a portfolio.
If you are looking to invest into 2 stocks equally, you can multiply their beta by 0.5 and add them together to get the combined portfolio beta
characteristic line
To calculate beta, we draw a line relating the expected return on the security to different returns on the market
Thus, a low R2 indicates that most of the risk of a firm is unsystematic
Know this
R squared
security market line (SML)
Positively sloped straight line displaying the relationship between expected return and beta.
tells us the reward offered in financial markets for bearing risk
market risk premium
Slope of the SML; the difference between the expected return on a market portfolio and the risk-free rate.
capital asset pricing model (CAPM)
Equation of the SML showing the relationship between expected return and beta.
The CAPM shows that the expected return for a particular asset depends on three things:
1) The pure time value of money. As measured by the risk-free rate, Rf, this is the reward for merely waiting for your money, without taking any risk.
2) The reward for bearing systematic risk. As measured by the market risk premium [E(RM) − Rf], this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting.
3) The amount of systematic risk. As measured by βi, this is the amount of systematic risk present in a particular asset, relative to an average asset.
Arbitrage Pricing Theory (APT)
An equilibrium asset pricing theory that is derived from a factor model by using diversification and arbitrage. It shows that the expected return on any risky asset is a linear combination of various factors.
In APT, Suppose there are three such factors: unanticipated changes in inflation, GNP, and interest rates. The total return can be expanded as:
R = E(R) + BiFi + Bgnp Fgnp + Br Fr + e
What is a measure of total risk?
Standard deviation
Total risk =
systematic risk + unsystematic risk
The unexpected return on a risky assets depends only on that assets
systematic risk
Total expected return =
Expected return + (beta x market risk premium) (This is CAPM)
What does the Beta number tell us?
A beta of 1: Implies the asset has less systematic risk than the overall market
A beta of less than 1: Implies the asset has less systematic risk than the overall market
A beta of more than 1: Implies the asset has more systematic risk than the overall market
What is a measure of systematic risk?
Beta
The security with the higher expected return will be the one that
expected returns
bigger
larger
has the higher Beta
