Chapter 13 Return, risk, and the security market line Flashcards
reward for bearing risk
risk premium
2 types of risk
- systematic
- unsystematic
highly diversified portfolios will tend to have no unsystematic risk
principle of diversification
the relationship between risk and return is shown
security market line (SML)
scenarios with particular probabilites
states of the economy
the return on a risky asset expected in the future
Expected return
(the expected return on a security is equal to the sum of the possible return multiplied by their responsibilities)
the difference between the return on a risky investment and the return on a risk free investment
Risk premium
How to determine the variance of returns on securities in 3 ways
- Determine the squared deviations from the expected return
- Multiply each possible squared deviation by its probability
- Sum the products of step 2
a group of assets such as stocks and bonds held by an investor
Portfolio
the percentage of a portfolios total value that is invested in a particular asset
Portfolio weight
(The expected return on a portfolio is the weighted average of the expected return of the assets in the portfolio)
The expected return on a portfolio is the weighted average of the expected return of the assets in the portfolio
substantially alter the risks faced by the investor
Portfolios increase diversification, thereby _____ risk
decreasing
The return on any stock traded in a financial market is composed of 2 parts
- Expected return: predicted by the market
- Unexpected return: comes from unexpected information revealed
In the long run the average value of unexpected returns will be zero, so on average the actual return equals
the expected return
a discounted announcement has less of an impact on the price because the market already knew much of it
Price in
a difference between the actual result and the forecast
Innovation/Surprise
Expected part of the anouncement formula is used by the market to form
expectations
Surprise in the anouncement formula influences the
unexpected return
a risk that influences a larger number of assets
Systematic risk/market risk
(Examples: GDP, interest rates, inflation)
All firms are susceptible to this
systematic risk
a risk that affects at most a small number of assets
Unsystematic risk/unique or asset specific risk
(Examples: pharmaceutical research breakthrough, oil strike)
the process of spreading an investment across assets (and thereby forming a portfolio
Diversification
spreading an investment across a number of assets will eliminate some, but not all, of the risk
Principle of diversification
2 key points of principles of diversification
- Some of the riskiness associated with individual assets can be eliminated by forming portfolios
- There is a minimum level of risk that cannot be eliminated by diversifying (nondiversifiable risk)
________ risk tends to wash out when assets are combine into portfolios, once there are more than just a few assets
unsystematic risk
Unsystematic risk is essentially eliminated by
diversification
(so a portfolio with many assets has almost no unsystematic risk)
______ risk cannot be eliminated by diversification
systematic
Also call non-diversifiable
systematic risk
the expected return on a risky asset depends only on that assets systematic risk
Systematic risk principle
No reward for bearing ________ risk because it can be eliminated at virtually no cost (by diversification)
unsystematic risk
the amount of systematic risk present in a particular risky asset relative to that in an average asset
Beta coefficient
An average asset has a beta of
1.0
The beta of the market is
1.0
Because assets with larger betas have greater systematic risks, they will have _______ expected returns
greater
The reward to risk ratio must be
the same for all the assets in the market
a positively sloped straight line displaying the relationship between expected return and beta
Security market line (SML)
Describes the relationship between systematic risk and expected return in financial markets
Security market line (SML)
the slop of the SML: which is the difference between the expected return on a market portfolio and the risk free rate
Market risk premium
the equation of the SML showing the relationship between expected return and beta
Capital asset pricing model (CAPM)
The CAPM shows that the expected return for a particular asset depends on 3 things
- The pure time value of money: as measure by the risk free rate, Rꜜf this is the reward for merely waiting for your money, without taking any risk
- The reward for bearing systematic risk: as measured by the market risk premium, E (Rꜜm) - Rꜜf , this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting
- The amount of systematic risk: as measured by bet, βi, this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset
the excess return as asset earns based on the level of risk taken
Alpha
The distance between actual return and the SML
alpha
an asset or portfolio has earned a return greater than what should have been earned based on its beta
Positive alpha
an asset or portfolio has earned a return less than what should have been earned based on its beta
Negative alpha
