Lecture 5-Risk & return II Flashcards
Possibilities with portfolio theory
Even with only two stocks we could create lots of different portfolios
Different percentage of each stock
With three stocks we could
create many more possible portfolios
Imagine the number of possible portfolios when you have thousands and thousands of possible stocks (and other assets!) to choose from
What is the efficient frontier in efficient portfolios?
- Is the collection of efficient portfolios
- They are efficient if they offer:
- The highest return for a given level of risk
- Lowest risk for a given level of return
- Rational investors only invest in efficient portfolios
The problems with rational investor and the efficient frontier
- It is difficult to estimate returns, SD and the correlation coefficients between investments
- For large portfolios calculations are complex
What is a riskless asset?
An asset whose future return is known today with certainty.
What is the capital market line (CML)?
is a graph that reflects the expected return of a portfolio consisting of all possible proportions between the market portfolio and a risk-free asset.
-With the introduction of a riskless asset, the CML becomes the new efficient frontier
What is Beta in risk?
Beta measures the volatility and systematic risk of a security
-Some stocks have more market risk than other-they are more affected by market factors
What is market risk?
experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved
-Cannot be eliminated through diversification, though it can be hedged against in other ways
What is hedging?
Hedging is done to minimize or offset the chance that your assets will lose value. It also limits your loss to a known amount if the asset does lose value.
Different types of Betas
- Stocks with high market risk, i.e. high betas, are called Aggressive stocks e.g. Car Manufacturers, Airlines
- Stocks with low market risk, i.e. low betas, are called Defensive stocks e.g. Utilities, Supermarkets
What does diversification aim to do?
- Aim to reduce the unique risk posed by an asset/Standard deviation
- Market risk cannot be decreased
- Highest return should be from the stock with the highest
What are some examples of a fixed beta?
- Riskless asset=0
- Beta of the market portfolio=1
- Tracker fund try to mimic market and have a beta of 1
What is the CAPM?
Relates the expected return from an investment to the market premium using beta as a measure of risk
- describes the relationship between systematic risk and expected return for assets, particularly stocks.
What is the risk free rate?
interest rate an investor can expect to earn on an investment that carries zero risk.
In practice, the Risk-Free rate is commonly considered to equal to the interest paid on 3-month government Treasury bill.
What is the market return?
The return on the overall theoretical market portfolio which includes all assets and having the portfolio weighted for value.
What is the security market line (SML)?
line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable securities plotted against the expected return of the entire market at a given point in time
What is the market risk premium?
The term “market risk premium” refers to the extra return that is expected by an investor for holding a risky market portfolio instead of risk-free assets.
-Expected market return - risk free rate
What does the expected return of CAPM consist of?
- Risk free rate
- Risk Premium
What is the risk free return normally generated from?
-Return on Government bonds or T-bills which are normally 3-4%
What does risk premium for an individual stock depend on
-Market risk premium
How do we find Beta?
- By looking at historical returns by picking a period of time
- Measure the return on the stock over that period and repeat for lots of periods
- Plot returns against stock returns
- The slope of the best fit line i s beta
What are negative betas?
- Expected return will be less than the risk free rate or even negative
- Will be negatively correlated to most other assets and so useful for diversification
- Gives protection against states with low aggregate wealth e.g. during a recession i.e acts as a form of insurance
What are the applications of CAPM?
To calculate the expected levels of return/For a given amount of risk, what level of return should be expected
To deliberately select high risk portfolios/Less risk averse investors may prefer these in the hope of making higher returns
-To identify mispriced shares
Abnormal returns can be made if shares not on the SML can be bought/sold before the market adjusts
What are the CAPM assumptions?
Investors are rational and risk averse
There are no taxes or transaction costs
All investors can borrow and lend as much as they like at the risk free rate
Investors can calculate the returns and risks for all investments
accurately measures systematic risk
Test of the CAPM
Remember, CAPM is an expectations model
We can only ever test realisations
Do ex ante expectations = ex post realisations
Lots of studies have tested CAPM
-Works ok for diversified portfolios over long periods
Doesn’t work very well for short periods and individual stocks
What are the problems with CAPM?
Investors cannot trade free of charge, or borrow/lend unrestricted at the riskless rate
- Investors do not hold the market portfolio
- Historical estimates of beta not accurate
- Over what period do you measure returns?
How many returns do you need to plot?
What is the return on the market
The FTSE100 or FTSE ALL Share are often used but they are not the complete market
-Does beta accurately capture all systematic risk?
