Lecture 2: Systematic Risk and the Equity Risk Premium (Chapter 12)

Question 1

What is portfolio weights?

Answer 1

It is the fraction of the total portfolio held in each investment in the portfolio. The total weights must always be equals 100%.

Wi = Value of investment / Total value of portfolio

Question 2

What is the return on a portfolio?

Answer 2

It is the weighted average of the returns on the investments in the portfolio, which weights corresponds to the portfolio weights.
Rp = W1R1 + W2R2 + … WnRn

Question 3

How do we calculate the expected return of a portfolio?

Answer 3

By calculating the weighted average of the expected returns of the investments within it, using the portfolio weights. It is the return you can expect to earn on your portfolio, given the expected returns of the securities in that portfolio and the relative amount you have invested in each.
E[Rp] = w1E[R1] + w2E[R2] + … wnE[Rn]

Question 4

How do we evaluate the overall expected return of a portfolio?

Answer 4

It is determined by the relative amount of money we have invested in it. If most of the money (>50%) is invested in a particular stock, then the overall expected return of the portfolio will be much closer to that stock’s expected return.

Question 5

What happens when we combine stocks in a portfolio?

Answer 5

Some risk can be eliminated through diversification. The remaining risk depends upon the degree to which the stock shares common risk.

Question 6

What is the volatility of a portfolio?

Answer 6

It is the total risk, measured as standard deviation of the entire portfolio.

Question 7

What are the 2 key takeaways from the the volatility of a portfolio?

Answer 7

1. By combining stocks into a portfolio, we are actually reducing risk through diversification since stocks do not move identically, thus some of the risks are averaged out in a portfolio.
2. The amount of risk that is eliminated depends upon the degree to which the stocks move together & face common risks.

Question 8

What are the 2 things that we need to know when finding the risk of a portfolio?

Answer 8

1. the risk of the component stocks

2. the degree to which they move together

Question 9

What is a correlation?

Answer 9

It is a barometer of the degree to which the returns share common risks. It ranges from -1 to +1.
The closer the correlation is to +1, the more the returns tend to move together as a result of common risk. This is normally for businesses in the same industry, affecting similarly by economic events.
When correlation = 0, it means that returns are uncorrelated and there is no tendency for returns to move together or even in the opposite direction of each other.
The closer the correlation is to -1, the more returns tend to move in opposite directions.

Question 10

When will volatility decline?

Answer 10

When the no. of stocks in a portfolio grows, then the volatility declines by diversification.

Question 11

What is the advantage of a large portfolio?

Answer 11

By selecting stocks w/ low correlation, we can achiev our desired expected return at the lowest possible risk.

Question 12

The sensitivity of individual stocks to risks

Answer 12

1. the amount of stock’s risk that is diversified away depends on its correlation w/ other stocks in the portfolio
2. w/ large enough portfolio, we can diversify away all unsystematic risk, but note that systematic risk will always remain

Question 13

What is a market portfolio?

Answer 13

It is the the portfolio of all risky investments, held in proportion to their value. Market portfolio contains more of the largest companies and less of the smallest companies. The sum of all investor’s portfolios must equal the portfolio of all risky securities in the market.

Question 14

Is it true that market portfolio only contains systematic risks?

Answer 14

Yes, therefore we can use it to measure the amount of systematic risk of other securities in the market. By looking at the sensitivity of a stock’s return to the overall market, we can calculate the amount of systematic risks the stock has.

Question 15

What is the formula for market value of a firm?

Answer 15

Market value of a firm (Market capitalization) = no. of shares outstanding x price per share

Question 16

What is a market proxy and what is its function?

Answer 16

It is a portfolio whose return should track the underlying, unobservable market portfolio. The most common proxy portfolios are market indexes.

Question 17

What is market index?

Answer 17

It reports the value of a portfolio of a particular portfolio of securities.

Question 18

What are the 2 famous market indexes?

Answer 18

1. Dow Jones Industrial Average (DJIA): consists of a portfolio of 30 large stocks, used as representative of different sectors of the economy, they do not represent the entire market.
2. S&P 500: a value weighted portfolio of 500 of the largest US stocks, standard portfolio used to represent the market.

Question 19

What is the best method used to measure systematic risk of a particular stock?

Answer 19

The market portfolio is a good basis for measuring systematic risk. We can use the relation between an individual stock’s returns and the market portfolio’s returns to measure the amount of systematic risk present. If a stock’s returns do not depend on the market returns, then it has little systematic risk.
In conclusion, stocks whose returns are volatile and are highly correlated w/ the market’s returns are the riskiest as they have the most systematic risk.

Question 20

What does Beta refer to?

Answer 20

It refers to the stock’s sensitivity to the market portfolio. It is the percentage change in the stock’s return that we expect for each 1% change in the market’s return.
It is the amount by which risks that affect the overall market are amplified or dampened in a given stock or investment.

Question 21

What is the Beta of the overall market portfolio?

Answer 21

The beta is 1, representing the average exposure to systematic risks.

Question 22

Why do beta vary across industries?

Answer 22

It is related to the sensitivity of each industry’s profits to the general health of the economy.

Question 23

What does high and low betas mean?

Answer 23

High beta: exposure to systematic risk is greater than the average (high volatility)
Low beta: very little relation to the state of economy (low volatility)

Question 24

How do we determine which stock has a larger total risk and which stock has more systematic risk?

Answer 24

Total risk is measured by standard deviation. Therefore, the higher the standard deviation, the higher the total risks.
Systematic risk on the other hand is measured by beta. The higher the beta, the more the systematic risks.

Question 25

In practice, what do we use to estimate the relation between a stock’s return and the market return?

Answer 25

We use the linear regression method to estimate the relation. The output is the best-fitting line that represents the historical relation between the stock and the market.
The slope of this best-fitting line is the estimate of beta, which tells us how much the stock’s excess return changed for a 1% change in the market’s excess return.

Question 26

How do we compute the cost of equity capital?

Answer 26

We have to first know the relation between the stock’s risk and its expected return.

Question 27

Is it true that only systematic risk determines expected returns?

Answer 27

Yes, because firm-specific risk (independent/ unsystematic risk) is diversifiable and does not warrant extra return.

Question 28

What are the 2 components making up the expected return on an investment?

Answer 28

1. a baseline rate of return to compensate for inflation and the time value for money, even when no risk of losing money
2. a risk premium that varies w/ the systematic risk

Expected return = Risk-free rate + Risk premium for systematic risk

Question 29

What is the market/ equity risk premium?

Answer 29

It is the historical average excess return on the market portfolio.

Question 30

What is the use of Capital Asset Pricing Model (CAPM)?

Answer 30

It is used to determine the equity cost of capital. Expected return on any investment is equal to the risk-free rate of return + a risk premium proportional to the amount of systematic risk in the investment.
Risk premium = market risk premium x systematic risk (beta of the investment) aka the investment’s required return.

Question 31

What is the Security Market Line?

Answer 31

CAPM implies that there is a linear relation between a stock’s beta and its expected return.
Risk-free investment: beta = 0
market rate: beta = 1

There is no clear relation between a stock’s standard deviation and its expected return.
The relation between risk and return for individual securities is only evident when we measure market risk rather than the total risk.

Question 32

The summary of the Capital Asset Pricing Model (CAPM)

Answer 32

• investors require a risk premium proportional to the amount of systematic risk they are bearing
• systematic risk can be measured using beta
• most common way to estimate beta is to use the linear regression, where the slope of the line is the stock’s beta
• we can compute the expected return of any investment using the equation,
  E[R] = rf + beta[E(Rm) - rf]