Business Finance Chapter 8
Which risk should matter to a rational diversified investor?
Market risk
What happens in a market dominated by risk-averse investors?
In a market dominated by risk -averse investors, riskier securities compared to less risky securities must have higher expected returns as estimated by the marginal investor. If this situation does not exist, buying and selling will occur until it does exist.
What if two investments with the same risk (standard deviation) but different expected returns, which one should be chosen?
Investors would generally prefer the investment with the higher expected return.
What does a standard deviation show?
It is a measure how far the actual return is likely to deviate from the expected return.
What is when the beta is 0.5
It is only half as volatile as the average stock and a portfolio of such stocks would rise and falls only half as rapidly as the market. Its risk would be half that of an averge-risk portfolio with b=1.
What is when the beta is 2.
It is twice as volatile as an average stock which means that it is twice as risky.
What about a portfolio consisting of low-beta stocks?
It will also have a low beta because the beta of a portfolio is a weighted average of its individual securities´betas.
What would buying pressure do with the stock price?
It would drive the stock price up
An asset´s risk can be analyzed in two ways
1) on a stand-alone basis, where the asset is considered by itself 2) On a portfolio basis, where the asset is held as one of a number of assets in a portfolio
Correlation Coefficient
A measure of the degree of relationship between two variables
Beta Coefficient
A metric that shows the extend to which a given stock´s returns move up and down with the stock market. Beta measures market risk.
Capital Asset Pricing Model (CAPM)
A model based on the proposition that any stock´s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.
Standard Deviation
A statistical measure of the variability of a set of observations
Security Market Line (SML) Equation
An equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.
Why is the beta the most relevant measure of a stock´s risk?
Because a stock´s beta coefficient determines how the stock affects the riskiness of a diversified portfolio, beta is, in theory, the most relevant measure of a stock´s risk.
Average Stock´s Beta
By definition b=1 because an average risk stock is one that tends to move up and down in step with the general market.
What about diversificaton
By diversifying wisely, investors can dramatically reduce risk without reducing their expected returns. Don´t put all of your money in one or two stocks or in one of two industries. A huge mistake that many people make is to invest a high percentage of their funds in their employer´s stock.
When is trying to reduce risk useless?
Diversification is completely useless for reducing risk if the stocks in the portfolio are perfectly positively correlated.
How can diversifiable risk be eliminated?
Either by holding very large portfolios or by buying shares in a mutual fund.
If a choice has to be made between two investments that have the same expected returns but different standard deviations which one should be chosen?
Most people would choosethe one with the lower standard deviation and therefore the lower risk.
When should no investment be undertaken?
No investment should be undertaken unless the expected rate of return is high enough to compensate for the perceived risk.
What would happen if we increased the number of stocks in a portfolio?
On average portfolio risk declines as the number of stocks in a portfolio increases.
Which returns matter?
Real returns are what matters. When assessing performance, the real return is what matters. It follows that as expected inflation increases, investors need to receive higher nominal returns.
Realized rates of return
Returns that were actually earned during some past period. Actual returns usually turn out to be different from expected returns except for riskless assets.
Risk Aversion
Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.
What would selling pressure do with the stock price?
Selling pressure would cause the price to fall.
Diversifiable risk
That part of a security´s risk associated with random events; it can be eliminated by proper diversification. This risk is also known as companyspecific, or unsystematic.
Market Risk Premium
The additional return over the risk free rate needed to compensate investors for assuming an average amount of risk.
Risk Premium
The difference between the expected rate of return on a given risky asset and that on a less risky asset.
What happens if a stock whose beta is greater than 1.0 is added to a b=1 portfolio?
The portfolio´s beta and consequently its risk will increase.
What about the portfolio risk?
The portfolio´s risk is generally smaller than the average of the stocks´ standard deviations because diversification lowers the portfolio´s risk.
Expected rate of return
The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results
What is Stand-Alone Risk?
The risk an investor would face if he or she held only one asset
What does the risk of an investment depend on?
The risk of an investment often depends on how long you plan to hold the investment.
Market Risk
The risk that remains in a portfolio after diversification has eliminated all company specific risk. This risk is also known as nondiversifiable or systematic or beta risk,
Relevant Risk
The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio´s market risk. It is measured by the extend to which the stock moves up or down with the market.
What about the size of the risk premium?
The size of the premium depends on how risky investors think the stock market is and on their degree of risk aversion.
What does the slope of the SML reflect?
The slope of the SML reflects the degree of risk aversion in the economy - the greater the average investor´s risk aversion, (a) the steeper the slope of the line and (b) the greater the risk premium for all stocks - the higher the required rate of return on all stocks.
The smaller the standard deviation...
The smaller the standard deviation, the tighter the probability distribution, and accordingly the lower the risk.
Coefficient of Variation (CV)
The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.
Correlation
The tendency of two variables to move together
Calculating risk definition
The tighter the probability distribution of expected future returns, the smaller the risk of a given investment.
What is the expected return on a portfolio?
The weighted average of the expected returns on the assets held in the portfolio.
Expected Return on a portfolio
The weighted average of the expected returns on the assets held in the portfolios
Where is the trade off?
There is a trade-off between risk and return. The average investor likes higher returns but dislikes risk. It follows that higher-risk investments need to offer investors higher expected returns. If you are seeking higher returns you must be willing to assume higher risk
What would the returns do of two perfectly positively correlated stocks with the same return?
They would move up and down together, and a portfolio consisting of these stocks would be exactly as risky as the individual stocks.
Betas and their risks
b=0.5: Stock is only half as volatile, or risky , as an average stock b=0: Stock is of average risk b=2: Stock is twice as risky as an average stock
How is the risk free rate also called and of which elements does it exist?
the nominal, or quoted, rate, and it consists of two elements: (1) a real inflation free rate of return r and (2) an inflation premium IP equal to the anticipated rate of inflation.
