Risk and Return Flashcards
Risk
Variance in returns
Measured using st dev.
Variance
1/n S(ri - ¡r)^2
Expected portfolio return
w1·r1 + w2·r2 + …. + wn·rn
Covariance
1/n S (rai - ¡ra)(rbi - ¡rb)
Why cov. to measure portfolio risk
Behaviour of stocks in relation to one another affects variance of portfolio returns
Portfolio Risk (cov)
w1^2·o1^2 + w2^2·o2^2 +2(w1·w2·cov12)
Magnitude of cov affected by
Stocks comovement
Stock’s indv. returns
Why correlation to measure risk
Hard to interpret cov as stocks indv. returns affect it
Correlation
cov12/(o1·o2)
Portfolio variance (corr.)
w1^2·o1^2 + w2^2·o2^2 +2(w1·w2·p12·o1·o2)
Notes on Portfolio Variance
o^2 -> find std dev. to measure risk
Add more stocks, add to the formula (comb. between all)
Types of risk
Specific (eliminated by diversification)
Market (cannot be eliminated)
Total risk = Specific + Market
Diversification
Strategy to reduce a portfolio’s specific risk by spreading the portfolio accross different securities
Well-diversified portfolio
Perfectly co-moves with market
Carries only market risk
Market portfolio
All assets in economy
Proxy with SP500
B
Stocks’ risk relative to the market
B=1 market portfolio
B=0 rf asset
o due to market risk
Bstock · Omarket
O due to market (meaning)
Risk of adding an extra stock to a well-diversified portfolio
Market risk for whole portfolio
Weighted average of the B of all stocks
(if well-diversified this is only risk)
Bi
covim/om^2
B from regression analysis
Slope of line of best fit in a historical graph of indv. returns (y) and market returns (x)
R^2 -> total variance in returns due to market risk
