Topic 9- Risk and Return Flashcards
Single asset or portfolio when it comes to returns…
single asset returns are more volatile than that of a portfolio
a portfolio is
a collection of assets
in a portfolio the weight of an asset determines…
how the asset contributes to the overall return
the return of a portfolio formula
sum of weight x return
the expected return of a portfolio
sum of: prob x return
std formula
square root of: sum of: prob x (return-expected return)^2
the std of a portfolio is the …
spread of returns about the expected return
std of a portfolio measures
the systematic + firm risk (total risk) for a stock
Total risk is
std
Systematic risk is
Beta
Diversification
means investing is more than 2 risky assets whose values don’t move in same direction at same time
if you have diversification combining risky assets into a portfolio risk is
offset due to the low correlations
diversification can be either
within 1 asset class (stocks but diff industries) or spread across classes (stocks, bonds…)
as you increase the number of stocks the std
decreases, but never approaches 0
2 types of risk
firm-specific risk/ unsystematic risk/ diversifiable risk
systematic risk/market risk/ non-diversifiable
firm specific /unsystematic risk/ diversifiable risk
unique risk to individual asset
which risk can be diversified away?
firm specific /unsystematic risk/ diversifiable risk
which risk are you compensated for?
systematic only
systematic risk is driven by
changes of macroeconomic factors
systematic risk measures the relationship between
returns of individual assets and returns of the most diversified portfolio (mafrket portfolio)
the expected return is the av of
probability of distribution of possible returns
the unexpected return is
driven by risk and the portion of inventory gain or loss due to unforseen circumstances
Beta
measure of systematic risk (non-diversifiable/market risk)
Beta is a measure of co….
covariance of stock with returns of a portfolio
The required return will be a
linear function of its beta
Expected return (inc rf rate)
= rf + (B(E(p)-rf))
Beta>1
above average risk
Beta=1
Average risk
Beta<1
Below average risk
Beta=0
riskless investment
Beta equation
weight x Bi
Beta is the slope of
the return of market index vs return for a stock
increased B means Increased
return
CAPM is
capital asset pricing model
CAPM eq
=rf+(B((E(rm)-rf))
in the CAPM equation which part is the market risk premium
(E(r)-rf)
in the CAPM equation which part is the risk premium
(B((E(r)-rf))
what is plotted on the security market line
expected return vs B
what does it tell us if assets and portfolios are not plotted on the security line?
the info of mispricing will be taken advantage of that they are over or underpriced
What is an appropriate return for an asset with no systematic risk?
risk free rate
The CAPM helps us as it tells us what …. will require from an investment with particular ….
rate of return
systematic risk
How do you work out the expected return for a single stock?
(pboom x S1(r)boom)+(bust x S1(r)bust)
How do you work out the portfolio’s expected return?
return (boom)= (ws1xr boom s1) +(ws2xr booms 2
return (bust)= same but for busts
expected return (p)= (p boom x r boom)+ (p bust x r bust)
The std (risk) of small stocks vs large stocks and then corp bonds vs treasury bills
small > large (because more risk)
corp > treasury
An increased variability means increased std means increased
return
stocks generally in the long run have a ……. than bonds
higher return than bonds
rational investors are against… in investment values
fluctuations (measured by volatility)
higher volatility means
higher return
investors need higher r in higher volatile investments since they do or don’t like risk
don’t like risk
if stock A is more volatile than stock but the arithmetic average is the same which stock will have a lower geometric average
A<B
