week 19 Flashcards
what are expected returns on a security
based on probabilities of possible outcomes
can be equated with average returns
how do you calculate expected return
sum of (probability of event occurring x expected return on asset)
what is a portfolio of securities
a collection of assets or securities
an assets risk and return impact and how it affects the risk and return of a portfolio
the risk and return trade-off for a portfolio, measured by portfolio expected return and standard deviation
what is the expected return of a portfolio
weighted average of expected returns for each asset in the portfolio
can also be calculated by finding the portfolio returns in each possible state and computing expected returns
what is the covariance of returns
measures how much the returns on two risky assets move together
what does the correlation coefficient show
-1 - perfectly negatively correlated, two stocks can be combined to form a riskless portfolio
0 - uncorrelated
+1 - perfectly positively correlated, no risk reduction at all
what is the difference between expected and unexpected returns
realised returns - generally not equal to expected returns
at any point in time an unexpected return can be positive or negative
overtime the average of the unexpected component is 0
what are the components of returns
total return = expected return + unexpected return
unexpected return = systematic portion + unsystematic portion
total return = expected return + systematic portion + unsystematic portion
what is systematic risk
risk factors that affect a large number of assets
also known as non-diversifiable risk, market risk or macro risk
what is unsystematic risk
risk factors that affect a limited number of assets
risk that can be eliminated by combining assets into portfolios
also called unique, diversifiable, asset-specific or micro risk
what is the principle of diversification
achieved by investing in several different assets or sectors with less than perfectly positive correlation
can substantially reduce risk without an equivalent reduction in expected returns
minimum level of risk that cannot be diversified away = systematic portion
what is total risk
systematic risk + unsystematic risk
= stand alone risk
for well-diversified portfolios unsystematic risk is very small
what is the systematic risk principle
there is a reward for bearing risk
there is no reward for bearing risk unnecessarily
the expected return on an asset depends only on that assets systematic or market risk
expected return = risk free rate + risk premium
how do you measure systematic risk
measured by a stocks beta coefficient
shows contribution of the security to the overall riskiness of a portfolio
relevant for stocks held in well-diversified portfolios
𝛽 = 1 - average risk
𝛽 > 1 - riskier than average
𝛽 < 1 - less risky than average
what is the risk premium
E(R) - rf
the higher the beta, the greater the risk premium should be
what is the risk to reward ratio
slope of the line of the graph
E(Ra) - Rf / 𝛽a
in equilibrium ratio should be the same for all assets
what should the risk to reward ratio be in market equilibrium
all assets and portfolios should have the same risk-to-reward ratio, each ratio should be equal to the market
what is the capital asset pricing model
defines the relationship between risk and return for any asset
if an assets systematic risk is known, CAPM and SML can be used to determine expected return
how do you calculate security market line (SML)
E(Ri) = rf + 𝛽(E(Rm) - rf)
what factors affect required return
rf - measures the pure time value of money
E(Rm) - rf - measures reward for bearing systematic risk
Bi - amount of systematic risk
