Topic 5- Introduction to Risk and Return Flashcards
What are the 3 main return measures of a stock?
- Holding period return (HPR): (P_t+Div_t/P_0) - 1
- Expected/mean return: E(r)
- Risk premium: E(r) - r_f
What is a maturity premium?
Extra average return from investing in long-versus short-term treasury securities
What is a risk premium?
Expected return in excess of risk-free return as compensation for risk
What is diversification?
Strategy designed to reduce risk by spreading a portfolio across many investments
What is unique/diversifiable risk?
Risk factors affecting only that firm
What is market/systematic risk?
Economy-wide sources of risk that affect the overall stock market
What is a portfolio?
A collection or combination of financial assets characterised by portfolio weights that sum to one
What is a portfolio’s (expected) rate of return?
The weighted sum of each asset’s rate of return
What is the formula for the expected return of an N-asset portfolio?
r_portfolio = w_1r_1 + w_2r_2 +…+ w_Nr_N = Σw_ir_i
where w_i is the weight of asset i in the portfolio
What is the formula for expected return of a 2-asset portfolio; r_a, r_b ?
r = ar_a + (1-a)r_b
where a is the proportion invested in one of the assets
What is the formula for the standard deviation of a 2-asset portfolio; r_a, r_b ?
σ = √[a^2(σ_a)^2 + (1-a)^2(σ_b)^2 + 2a(1-a)(ρ_a,b)(σ_a)(σ_b)]
where ρ_a,b is the correlation coefficient/covariance between r_a & r_b
How does portfolio risk change with correlation between the assets?
Portfolio risk decreases as correlation decreases
How does unique risk change with the number of stocks in a portfolio?
As the number of stocks in a portfolio increases, unique risk decreases and approaches zero
