lecture 4: meaning and measurement of risk and return pt.2 Flashcards
rates of return: investor’s experience
-shows direct relationship between risk and return
-only common stock provides a reasonable hedge against inflation
-from 1926 to 2016, large stocks had negative returns in 22/91 years and US treasury bills generated negative returns in one year
risk and diversification
-total risk of portfolio is due to two types of risk
1) systematic risk (affects all firms e.g. tax rate changes, wars)
2) unsystematic risk: only affects specific firms (CEO changes/labour strikes)
-systematic is non-diversifiable risk, unsystematic risk is diversifiable risk
correlation and risk reduction
-main motive for holding multiple assets or creating a portfolio of stock is to reduce overall risk exposure
-degree of reduction depends on correlation between assets
-if two assets are perfectly positively correlated, diversification has no effect on risk
-if the two assets are perfectly negatively correlated, the portfolio is perfectly diversified
-thus, while building a portfolio, we should pick assets that have negative or low positive correlation
risk and diversification demonstrated
-the market rewards diversification
-through effective diversification, we can lower risk without sacrificing expected return, and we can increase expected returns without having to assume more risk
monthly holding return and average holding-period return
(price end of month-price beginning)/price beginning
(return month 1 + return month 2 +…+ return month n)/number of monthly returns
characteristic line and beta
-characteristic line= line of best fit for all stock returns relative to a portfolio
-slope is beta, measures of firm’s market risk
interpreting beta
-beta is the measure of risk that remains for a company even after we have diversified portfolio
-a stock with beta 0 has no systematic risk
-a stock with beta 1 has systematic risk equal to typical stock in market (market average)
-a stock with beta>0 has systematic risk greater than typical stock (market average)
-most stocks have beta between 0.6 and 1.6
total risk, systematic risk and beta
-an assets investment or total risk is measured by variance and standard deviation
-variance and standard deviation are appropriate measures of risk if you are investing in a single risky asset
-an asset’s systematic risk is measured by beta
-beta is the appropriate measure of risk if you are investing into a well-diversified portfolio
portfolio beta
-portfolio beta is weighted average of the individual securities’ betas
-=wjxbj
-w is % invested in stock j
-b is beta of stock j
how to calculate portfolio weights
-portfolio weights= amount invested in equity x/total amount invested
how to calculate: expected return on a portfolio and portfolio betas
-expected return on portfolio:
sum of (expected return x portfolio weight)
-portfolio betas- solution (beta x portfolio weight)
systematic risk and beta- summary
-unsystematic risk can be largely eliminated through diversification
-investors only rewarded for systematic risk they bear
-risk premium on an asset is therefore determined by its systematic risk
-an assets systematic risk, relative to average is determined by beta
-beta of a portfolio is the weighted average of the beta values of the constituent assets
investor’s required rate of return
-investor’s required rate of return is minimum rate of return required to purchase/ hold a security
-= risk-free rate of return + risk premium
risk-free rate
-required rate of return or discount rate for risk-free investments
-risk-free rate is typically measured by US treasury bill rate
risk premium
-additional return we must expect to receive for assuming risk
-as risk level increases, we will demand additional expected returns
Capital Asset Pricing Model (CAPM) and equation
equates expected rate of return on a stock to the risk-free rate + risk premium for systematic risk
=Rf+Bi[E(Rm)-Rf)
risk free rate
beta
market risk premium
what does CAPM model depend on
1) pure time value of money (reward for waiting for money without taking on risk)
2) reward for bearing systematic risk (market risk premium)
3)amount of systematic risk
(measured by beta, amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset)
Security Market Line (SML)
-graphical representation of CAPM, where the line shows the appropriate required rate of return for a given stock’s systematic risk
-predicts expected return based on level of systematic risk and can identify mis-priced securities
example of CAPM
if CAPM derives expected return lower than actual expected return, it means the equity is underpriced
