Finance, Chapter 8, Risk

Capital asset pricing model (CAPM). Diversifiable versus non-diversifiable risk

Diversifiable: represents portion of an asset's risk that is associated with random causes that can be eliminated through diversification Non-diversifiable: attributable to market factors that affect all firms; cannot be eliminated through diversification Links nondiversifiable risk to expected returns

Calculate expected return. Understand definition and intuition behind standard deviation.

E(R) = w1R1 + w2Rq + ...+ wnRn weighted average of the likely profits of the assets in the portfolio, weighted by the likely profits of each asset class

Risk aversion and the pricing of risk in stocks

Investors who are risk adverse prefer less risky over more time investments

Basics of assessing risk: scenario analysis, range of possible returns

Scenario analysis: approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns. One common method involves considering pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the returns associated with them for a given asset. Range of possible returns a measure of an asset's risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome

What is the definition of risk?

a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset

What is a probability distribution? What are characteristics of normal distribution?

a model that relates probabilities to the associated outcomes

What is an efficient portfolio?

a portfolio that provides the maximum return and the standard deviation of a portfolio of assets

What is correlation and why does it matter for assets in the portfolio?

a statistical measure of relationship between any two series of numbers the degree of correlation is measured by the correlation coefficient perfectly positive correlated +1 perfectly negative correlated -1

How to compute the total return on an asset.

asset's cash distributions during the period + change in value / its beginning-of-period investment value

Nominal versus real returns.

nominal rate of return is the amount of money generated by an investment before factoring in expenses such as taxes, investment fees and inflation

Where do diversification benefits come from?

to reduce overall risk, it is best to diversify by combining or adding to the portfolio