Week 9 Flashcards
What is common risk?
perfectly correlated (risk of loss is perfectly correlated; all others will be the same)
What is independent risk?
not correlated with other losses (unique, not affecting all)
What is diversification?
averages out independent risks (can’t do anything about common risk)
Take standard error when risks are…
- Identical: the same as others
- Independent: not correlated
Formula for Percentage Return
Percentage return = capital gains yield + dividend yield
Percentage return = ((ending price – beginning price) / beginning price) + (Dividend / beginning price)
What is risk?
What happened may differ from what was expected (or would like to happen)
The larger the volatility (standard deviation or variance) …
the greater the risk
What is diversifying risk?
reducing volatility for given level of return by grouping assets into portfolios
Diversification has no effect on risk when…
Two stocks that are perfectly positively correlated
What are some caveats of CAPM?
- Beta can vary deepening how it is calculated
- Risk/return relationship rest on the assumption that the stock (or asset) is priced correctly
- Requires markets are efficient
What does CAPM tell?
CAPM will tell how much return will be required for holding an asset relative to the risk-free rate and market portfolio
Portfolio is inefficient if…
you can find another portfolio that has a better expected return without having a higher volatility
What does Sharpe ratio measure?
Measures the risk to reward of a portfolio
Measures the ratio to reward-to-volatility provided by a portfolio
Formula for Sharpe ratio
Sharpe Ratio = Excess Return of the portfolio / volatility of the portfolio = (rp – rf) / SD(rp)
Sharpe ratio = portfolio excess return / portfolio volatility = E(rp) – rf)/ SD(rp)
What is an efficient portfolio?
no way to reduce the volatility of the portfolio without lowering its expected return
- Efficient portfolio can only be achieved by purchasing a diversified portfolio
