Topic 7 Flashcards
Average returns were used to analyse _______ returns in financial markets based on actual events.
historical
__________ of returns of an investment represents its risk and is measured by variance and standard deviation.
Variability
In Part 2, we calculate projected future returns based on probabilities of economic state in future. We call these ___________.
expected returns
________ is a group of assets held by an investor.
Portfolio
___________ is how many percents a particular asset contributes to the total value of the portfolio.
Portfolio weight
_________ on a portfolio is calculated based on portfolio weight.
Expected return
What will determine the value of a share’s return next year?
There are two components: expected and unexpected returns.
Expected return is part of the return that investors already predict, based on the information the shareholders have _______ that will influence the return in upcoming year
today
Unexpected return is the ________ part; the portion that comes from unexpected information revealed within the year, for example:
+ unexpected change in commodity prices (imagine if iron ore prices suddenly fall sharply!)
+ News that company’s sales figures are better than expected
+ News about the CEO’s sudden resignation.
risky
Total return = Expected return + _________ return
R = E(R) + U
Unexpected
So, what is risk?
Risk is the unexpected part of the total return!
Unexpected events comprising the unexpected part of total return can be divided into:
– Systematic risk: Risk affecting a large group of investments; also called _______
– Non-systematic risk: Risk affecting only a single or a small group of investments; also called _______
market risk.
unique risk.
Total return = __________ + Systematic portion + Non-systematic portion
Expected return
THE EFFECT of DIVERSIFICATION:
- If a portfolio contains a number of diversified shares, its standard deviation would be _______ than the average standard deviation of individual share.
- The more the number of shares in the portfolio, the _______ the portfolio’s standard deviation.
lower
lower
A relatively large and diversified portfolio has almost no _________ risk.
non-systematic
Systematic risk principle states that, because non-systematic risk can be eliminated by diversification, expected return on a risky asset depends only on the asset’s ________
systematic risk.
So, how do we measure systematic risk?
Beta coefficient (β) measures the amount of systematic risk in a particular investment relative to an average risky investment in the market.
+ An investment with a beta of 0.50 has half the systematic risk that an average risky investment has.
+ A beta of 2.00 means the investment has twice the systematic risk an average risky investment has.
Because the expected return on a risky asset depends on systematic risk, the _______ the beta of an asset, the _______ the expected return
higher
higher
Portfolio beta is measured based on ___________. Example: If a portfolio has 70% investment in Share A (beta = 1.58) and 30% in Share B (beta = 0.86), the beta of the portfolio is:
βP = (0.70 x 1.58) + (0.30 x 0.86)
= 1.10 + 0.26
= 1.36
portfolio weight
The security market line (SML) shows the relationship between _________ and beta.
expected return
Capital asset pricing model (CAPM) is the ________ showing the relationship between expected return and beta.
formula
The formula shows CAPM has three components:
+ Pure time value of money, as measured by the _______, which is the reward for merely waiting for your money without taking any risk
+The reward for bearing systematic risk, as measured by market risk premium [E(RM) – Rf], which is the amount of reward for bearing the systematic risk of an average risky asset in the market
+The amount of systematic risk, as measured by beta, which is the amount of systematic risk present in the asset, relative to an average risky asset
risk-free rate
Expected return: return on a risky asset expected __________.
in the future
We can calculate the ________ or expected risk premium as the difference between the expected return on a risky investment and the certain return on a risk-ree investment.
projected
The economy has equal probability of going into recession, boom or remaining at the current level. The current level of return for a firm is 8%. It is forecast to return 12% in a boom period and 4% in recession. What is the expected return for the firm?
Expected return = [12% + 8% + 4%]/3 = 8%
Portfolio: ______ of assets, such as shares and debentures, held by an investor.
group
Portfolio weight: ______ of a portfolio’s total value in a particular asset.
percentage
Total return = Expected return + ________ return
Unexpected
Please explain what part of this information reflects surprise to market participants. Before the market opened on 3 May 2012, Westpac announced a 1% drop in cash earnings for the half year to March 2012. Fortunately, the share price increased by 17 cents at the open, in spite of a slightly weaker opening for the market from the closeof the day before. Seven days later rival National Australia Bank announced that its corresponding half - year cash earnings increased by 1.3%. Its price dropped by 9 cents. The market again experienced a relatively flat open
The data suggests that as the market expected cash earnings to drop by more than 1 per cent for Westpac, Westpac’s results was acceptable to the market. National Bank’s earnings would appear to have disappointed slightly. Another reason for these movements could be the political problems Greece was experiencing during this period, which in turn may have affected the market’s interpretation of the accurancy of the individual banks’ future earnings projections
The risk of owning an asset comes from surprises— ________ events
unanticipated
The first type of surprise, Systematic risk: a risk that influences a _____ number of assets. Also market risk
large
The second type of surprise: Non-systematic risk: a risk that affects at most a ________ number of assets. Also unique or asset-specific risk
small
Principle of diversification: _____________________________________________
Principle stating that spreading an investment across a number of assets will eliminate some, but not all, of the risk
Diversification reduces risk, but only up to a point, as market risk will always be ______
present
Non-systematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no ________ risk
non-systematic
Systematic risk principle: ____________________________________
principle stating that the expected return on a risky asset depends only on that asset’s systematic risk
Beta coefficient: amount of systematic risk present in a _______ risky asset relative to an average risky asset.
particular
The important thing to consider is that the expected return, and thus __________, on an asset depends only on an asset depends only on its systematic risk. Since assets with larger betas have greater systematic risks, they will have greater expected returns.
the risk premium
Consider the following information on two securities. Which has greater total risk? Which has greater systematic risk? Greater non-systematic risk? Which asset will have a higher risk premium?
Security A: Standard deviation: 35%, Beta 0.4
Security B: Standard deviation: 15%, Beta 1.6
From our discussion in this section, security A has greater total risk, but it has substantially less systematic risk. While total risk is the sum of systematic and non-systematic risk, security A must have greater non-systematic risk. Finally, from the systematic risk principle, security B will have a higher risk premium and a greater expected return, despite that fact that it has far less total risk
A risk-free asset, by definition, has no systematic risk ( or non-systematic risk), so a risk-free asset has a beta of _____
0
Our basic argument can be extended to more than just two assets. In fact, no matter how many assets we had, we would always reach the same conclusion:
The reward-to-risk ratio must be the _______ all assets in the market.
same
If one asset has twice as musch systematic risk as another asset, its ________ will simply be twice as large.
risk premium
Suppose the risk-free rate is 5%, the market risk premium is 7%, and a particular share has a beta of 1.2. Based on the CAMP, what is the expected return on this share? What would the expected return be if the beta were to double?
With a beta of 1.2, the risk premium for the share shuld be 1.2x7%, or 8.4%. The risk-free rate is 5%, so the expected return is 13.40 per cent. If the beta doubles to 2.4, the risk premium would double to 16.8 per cent, so the expected return would be 21.8 per cent
