Topic 12: Return, Risk and the Security Market Line II (Sem 2) Flashcards
Systematic Risk
A risk that influences a large number of assets.
Also known as ‘Market risk’
Notes: Investors are only rewarded for the systematic risk they bear, and the risk premium is determined by systematic risk.
Unsystematic Risk
A risk that affects at most a small number of assets also known as ‘unique’ or ‘asset-specific’ risk.
Note: Unsystematic risk can be eliminated by diversification. Meaning a portfolio with many assets has almost no unsystematic risk.
Total Risk Formula
Total Risk = Systematic + Unsystematic Risk
The Systematic risk principle
The expected return on a risky asset depends only on that assets systematic risk.
The Beta Coefficient
Determines systematic risk: The amount of systematic risk present in a particular risky asset relative to that in an ‘average’ risky asset.
Note: An assets investment or total risk is measured by variance and standard deviation these are capable of measuring risk if you are investing in a single risky asset.
However Beta is used to measure risk of a well diversified portfolio.
Beta Coefficient values
Beta coeffecient measure the volatility of an individual stock compared to the market. The market is a proxy for the ‘average’ risky asset Therefor, a beta value of:
> 1 means more systematic risk than the average risky asset
= 1 means the systematics risk is the same as the average risky asset
< 1 means less systematic risk than the average risky asset.
Portfolio Betas (Formula)
Bp = (Wx * Bx) + (Wy * By)
The beta of a portfolio is simply the weighted average of the asset multiplied by beta of asset.
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Weighted Average calculation steps
1) Multiply all value in the data set by their corresponding weights.
2) Add up the resulting products and
3) Divide by the sum of the weights
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The reward to risk ratio (Formula)
In equilibrium, the reward to risk ratio must be the same for all assets in the market:
The formula is: The ratio of an asset’s risk premium, (E(Ra)-Rf) to it’s beta, Ba:
(E(Ra)-Rf)Ba
In a well functioning market the reward to risk ratio is the same for every asset.
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The Security Market Line
A positively sloped straight line displaying the relationship between expected return and beta.
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Market Portfolio
A theoretical portfolio made up of all the assets in the investment universe weighted according to their market value.
Expected return on the market E(Rm)
Is the expected return on the market as a whole
contains all the assets in the market, so it has an ‘average’ beta value of one
Reward to risk ratio for the market (Formula)
(E(Rm)-Rf)
In other words the slope of the security market line is the market risk premium.
The slope of the line is the difference between the expected return on a market portfolio and the riskfree rate.
Capital Asset Pricing model (CAPM)
E(Ri) = Rf + Bi * [E(Rm) - Rf]
This is the equation of the security market line it shows the relationship between expected return of an asset and it’s beta.
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The expected return for an asset depends on three things
1) The pure time value of money
Measured by the risk-free rate, Rf
This is the reward for simply waiting for your money without taking any risk.
2) The reward for bearing systematic risk
As measured for the market risk premium: E(Rm) - Rf
This component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting.
3) The amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset.
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