Week 8: Risk and Return - Part 3 Flashcards
Risk measurement.
Known probability distribution.
Risk refers to: “any deviation from the expected value”
What is a portfolio?
Portfolio is a combination or collection of investment securities.
Weight: individual investment’s dollar value scaled by portfolio’s dollar value.
Summation of weights should be equal to 1 (100%).
Diversifiable and non diversifiable risk.
Diversifiable - firm specific risk
Non diversifiable - Mark risk
What is the beta coefficient?
A measure of the extent to which the returns on a given stock move with the stock market. (Measures the sensitivity of an individual to the market).
This measures market (systematic) risk.
Portfolio risk.
Portfolio risk is lower than the weighted average risk of constituents.
A portfolio is more diversified than its constituents (held individually).
What three factors determine the risk (standards deviation)of a portfolio?
. Standard deviation of constituents
. Weights of constituents
. The covariance/correlation between returns on constituents
Covariance.
Similar to variance, we use covariance to measure co-movement.
If covariance is positive: x and y move in the same direction
If covariance is negative: x and y move in the opposite direction
Correlation.
Detects any systematic relationship between series of numbers.
Direction of relationship:
. Positive - two series move in the same direction
. Negative - two serious move in opposite direction
Diversification.
By combining assets with low or negative correlation,new reduce the overall risk of the portfolio.
If there is pos relationship then both will fall when one falls, meaning more damage.
Correlation coefficient (p) interpretation.
P = +1 —– perfectly positive correlation
0 < p < +1 —– positive correlation
P = 0 —– no correlation
-1 < p < 0 —– negative correlation
P = -1 —– perfectly negative correlation
Risk and diversification.
Diversification can only eliminate unsystematic risks.
Almost all possible gains from diversification are achieved with a carefully chosen portfolio of approximately 30-40 shares.
Systematic risks are unchanged.
Unsystematic risk reduces exponentially ask number of shares increases.
Beta coefficient interpretation.
B < 1 —– the stock is LESS risky (volatile) than the market
B = 1.0 —– the world has the SAME risk as the market
B > 1 —– the stock is MORE risky than the market
Benchmark beta coefficient: market beta (= + 1)
Difference between beta and standard deviation.
Beta: . Deviation from market . Systematic risk . Non-diversifiable . Can be negative
Standard deviation: . Deviation from mean (expected return) . Total risk . Unsystematic part is diversifiable . Can NEVER be negative
