Chapter 8 - Risk and Rate of Return
Expected Rate of Return
An asset's expected return is calculated as the statistical mean, or average, of the probability distribution of its possible returns, and represents the rate of return expected to be realized from an investment.
Beta Coefficient
An investment's beta coefficient (β) reflects the extent to which the returns on a given investment are correlated with the returns of a market portfolio. Beta measures the systematic, or market, risk of an investment or firm. An investment with a beta of 1.0 exhibits a level of risk, or return variation, equal to that of the market, while investments with a beta less than 1.0 exhibit less systematic risk (return volatility) than the market. The returns of companies and investments with betas greater than 1.0 exhibit volatility that is greater than that exhibited by the returns on the market portfolio.
when expected return > required return
Do invest, because the stock is considered undervalued and investors will purchase the stock until the expected return = required return.
Describe how to determine the rate of return that investors should earn for purchasing an investment.
Investors should be rewarded for relevant risk only (the investment's systematic risk). Because the market as a whole is considered perfectly diversified, its variability (risk) is related to systematic risk only, and thus the market can be used as a benchmark for measuring the systematic risk of any investment. As a result, the systematic risk associated with an individual investment can be determined by computing the relationship between the investment's variability and the variability of the market. This relationship, which is called the beta coefficient (β), indicates whether the investment's relevant risk is higher than , lower than , or equal to that of the market.
Explain what it means to take risks when investing
Risk is defined as the possibility that you will not earn the return you expect when investing. Stated differently, risk exists when an investment has more than one possible outcome. Some risk can be considered "good" because greater returns than expected are possible, whereas some risk is "bad" because lower returns than expected are possible.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a theoretical model used to calculate the appropriate required return on a security as the sum of the market's risk-free rate and a risk premium based on the market's risk premium and the security's beta coefficient. To calculate the return on asset j, (rj) the CAPM is expressed as: rj=rRF+(rM−rRF)×βj where, rRF is the return earned on a risk-free rate, rM is the return earned on the market portfolio, and βj is the measure of the volatility of asset j's returns relative to the market portfolio.
Coefficient of Variation
The coefficient of variation (CV) is a statistical variable calculated by dividing the standard deviation of an investment's returns by its mean, or expected return, represents a security's risk per unit of return. In terms of investments, the CV provides a standardized measure of a security's risk per unit of return, and is useful in comparing the expected returns of different investments.
Diversification
The practice of creating a portfolio of assets for the purpose of reducing the stand-alone risk of the individual assets in the portfolio. The benefits of diversification are only realized if the returns on each asset added to the portfolio exhibit less than perfect correlation with the portfolio's returns. Adding assets whose returns are perfectly correlated with the those of the portfolio will not reduce the riskiness of the portfolio.
Explain how the risk and return of an investment are related
The risk associated with an investment is determined by measuring the variability of returns, or average deviation from the expected return. The expected return on an investment is the weighted average return investors will earn over a long period of time if the probability distribution associated with the investment is correctly specified. Generally, investments with greater risk earn higher rates of return because their risk premiums are higher.
Identify relevant and irrelevant risk, and explain how irrelevant risk can be reduced.
The total risk of an investment consists of (1) firm-specific (unsystematic) risk, which is caused by events that are unique to a particular firm and can be reduced or eliminated through diversification, and (2) market (systematic) risk, which stems from factors that affect the general economy and thus cannot be reduced through diversification. Relevant risk refers to the risk investors must take; thus, the relevant risk for an investment is its systematic, or market, risk because it cannot be eliminated.
Riskier investments must have higher expected returns than less risky investments
True, otherwise, people will not purchase investments with higher risks.
Generally, investors would prefer to invest in assets that have
a low level of risk and high expected returns. As an investor, you want to maximize the returns from your total investments for the given level of risk. When the exposure to risk is high, expectations for return are also high. Thus, if you invest in an asset with high risk, you should expect a high rate of return.
Market risk
also called nondiversifiable risk, is the risk that cannot be diversified away by adding additional assets to an investment portfolio. Nondiversifiable risk results from the systematic events and factors that affect all investments. Examples include inflation, interest rate risk, political risk, and exchange rate risk. It is also that portion of an investment's risk calculated as the difference between its total risk and its firm-specific risk.
The effects of nondiversifiable risk, which is also labeled systematic risk or market risk or relevant risk, can be determined by computing...
computing the beta coefficient (b) of an investment. The beta coefficient measures the volatility of an investment relative to the volatility of the market, which, in theory, is perfectly diversified and thus is affected only by systematic risk.
A stock is deemed to be in equilibrium when
expected return, r^, equals the return investors require (demand), r
Equilibrium
is a market condition in which the expected return on a security equals its required return, and there is no pressure on its price to change. This condition of price stability results from the equality of a security's expected and required returns.
Risk
is the possibility that the actual return or outcome exhibited by an asset will be better or worse than its expected return or outcome. The potential for deviation from an asset's expected performance means that there is more than one possible outcome. The existence of these multiple outcomes means that the asset possesses risk. The opposite of a "risky" asset is a risk-free asset. What makes an asset, such as a U.S. Treasury bill or bond and FDIC insured savings accounts, risk free is that there is only one possible outcome associated with owning the security until maturity.
Risk Premium
refers to that portion of an asset's total expected return required by investors as compensation for assuming the additional risks associated with the security, the issuer, and the marketplace. Risk premium are required to compensate investors for their exposures to systematic risks, including default, liquidity, interest rate, political, and exchange rate risks.
According to capital asset pricing model (CAPM), an investment's required rate of return can be computed as
rj = rRF + (rRF - rM) β
Stand-alone risk
the risk an investor would face if he or she held only one asset. As an investor, if you hold a single asset, you bear the risk of receiving much less, or much more, than expected from that particular asset. This kind of risk is referred to as stand-alone risk. Stand-alone risk measures the undiversified risk of an individual asset.
When the expected return < required return
the stock's market price P0 will be less than its intrinsic price, P^ (Present value) Do not invest
