Lecture 6: Risk, Return and the CAPM

Question 1

what sthe relationship between volatility and risk?

Answer 1

The greater the volatility the greater the risk of an investment

Question 2

what is diversification?

Answer 2

The strategy of investing in more than one asset to reduce investment risk (variance/volatility) is called diversification

Basic idea behind diversification: do not put all your eggs in one basket.

Diversification is supposed to reduce investment risk when the assets in the portfolio have low correlation

Question 3

What is systemic risk?

Answer 3

Systematic risk is the risk stemming from the market and affects all assets

• These include recessions, interest rate changes, war, government policy etc

Investors cannot eliminate such risks because they are external

Question 4

What is Unsystematic risk ?

Answer 4

Unsystematic risk is specific to a given company

• Includes employee strikes, fire in the building, bad CEOs etc 

investors can eliminate this risk by diversification

Question 5

What is beta ( β )?

Answer 5

Market risk of an asset is measured by its beta ( β ).

Beta is a measure of the sensitivity of asset (i.e., stock) returns to the fluctuations of the market

Question 6

What is regression analysis?

Answer 6

Regression Analysis: Statistical framework analyzing the impact of X on Y

Example: How does marketing expenses (X) impact profitability (Y)

Y = a + b * X

a: constant, b: sensitivity of Y on movements of X

Question 7

What are the CAPM implications?

Answer 7

CAPM implications:

Investors are getting rewarded only for bearing systematic risk (i.e. bearing beta)

The risk – return relationship is linear

3) Assets with higher risk (beta) should have higher required (expected) returns

4) Assets with β = 0 should provide an expected return equal to a riskless asset (𝑟_𝑓)

5) Assets with β = 1 should provide an expected return equal to the market (𝑟_𝑚)