CH. 13: Return, Risk, and the Security Market Line

THE PRINCIPLE OF DIVERSIFICATION

*Highly diversified portfolios will tend to have almost no unsystematic risk. *Tells us that spreading an investment across many assets will eliminate some of the risk. * risk reduction from adding securities drops off as we add more and more

THE VARIABLES OF CAPM

* Rf* the pure time value of money--the reward for waiting for your money, without taking any risk. * E(RM) − Rf* The reward for bearing systematic risk--The reward for bearing systematic risk. *βi* The amount of systematic risk

The SECURITY MARKET LINE (SML)

*A positively sloped straight line displaying the relationship between expected return and beta. *The slope of the SML—the difference between the expected return on a market portfolio and the risk-free rate.

PORTFOLIO BETAS

*Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. *Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns.

EFFECTS OF DIVERSIFICATION

*Standard deviation declines as the number of securities is increased.

SYSTEMATIC v. UNSYSTEMATIC RISK

*Systematic--systematic risk affects almost all assets in the economy, at least to some degree. * Because systematic risks have market-wide effects, they are sometimes called market risks *UNSYSTEMATIC--affects at most a small number of assets--Because these risks are unique to individual companies or assets, they are sometimes called unique or asset-specific risks.

EXAMPLES OF UNSYSTEMATIC RISKS

*The announcement of an oil strike by a company will primarily affect that company and, perhaps, a few others (such as primary competitors and suppliers)--It is unlikely to have much of an effect on the world oil market, however, or on the affairs of companies not in the oil business, so this is an unsystematic event.--unsystematic risk can be essentially eliminated by diversification.

DIVERSIFICATION

*The process of spreading an investment across assets (and thereby forming a portfolio)

EXAMPLES OF SYSTEMATIC RISKS

*Uncertainties about general economic conditions (such as GDP, interest rates, or inflation) are examples of systematic risks. * cannot be eliminated by diversification.

SYSTEMATIC RISK PRINCIPLE

No matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

CAPITAL ASSET PRICING MODEL (CAPM)

The equation of the SML showing the relationship between expected return and beta.