Exam 4: Chapter 12

the expected return on any investment should come from 2 components:

1. A baseline risk-free rate of return that we would demand to compensate for inflation and the time value of money, even if there were no risk of losing our money. 2. A risk premium that varies with the amount of systematic risk in the investment.

value-weighted portfolio

A portfolio in which each security is held in proportion to its market capitalization. -A capitalization-weighted index is a type of market index with individual components that are weighted according to their total market capitalization. The larger components carry higher percentage weightings, while the smaller components in the index have lower weights. This type of index is also known as a market value-weighted index.

Capital Asset Pricing Model (CAPM)

An equilibrium model of the relationship between risk and return that characterizes a security's expected return based on its beta with the market portfolio. -the CAPM simply says that the return we should expect on any investment is equal to the risk-free rate of return plus a risk premium proportional to the amount of systematic risk in the investment

The amount of risk that is eliminated in a portfolio depends upon the....

DEGREE TO WHICH THE STOCKS FACE COMMON RISKS AND MOVE TOGETHER.

negative beta

Negative beta. A beta less than 0, which would indicate an inverse relation to the market, is possible but highly unlikely. However, some investors believe that gold and gold stocks should have negative betas because they tended to do better when the stock market declines

beta (β)

The expected percentage change in the excess return of a security for a 1% change in the excess return of the market (or other benchmark) portfolio. -A stock's beta (β) is the percentage change in its return that we expect for each 1% change in the market's return. -Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark. 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. Beta is also known as the beta coefficient.

The most common way to estimate a stock's beta is to...

The most common way to estimate a stock's beta is to regress its historical returns on the market's historical returns. The stock's beta is the slope of the line that best explains the relation between the market's return and the stock's return.

security market line (SML)

The pricing implication of the CAPM; it specifies a linear relation between the risk premium of a security and its beta with the market portfolio. -The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable securities plotted against the expected return of the entire market at a given point in time. Also known as the "characteristic line," the SML is a visual of the capital asset pricing model (CAPM), where the x-axis of the chart represents risk in terms of beta, and the y-axis of the chart represents expected return. The market risk premium of a given security is determined by where it is plotted on the chart in relation to the SML

Volatility _______ as the number of stocks in the portfolio grows.

Volatility DECLINES as the number of stocks in the portfolio grows.

We can measure the systematic risk of an investment by its ____, which is the sensitivity of the investment's return to the market's return. For each 1% change in the market portfolio's return, the investment's return is expected to change by ____ percent due to risks that it has in common with the market.

We can measure the systematic risk of an investment by its β, which is the sensitivity of the investment's return to the market's return. For each 1% change in the market portfolio's return, the investment's return is expected to change by β percent due to risks that it has in common with the market.

equally weighted portfolio

a portfolio in which the same amount of money is invested in each stock

cyclical stocks

ex: Hewlett Packard, Abercrombie & Fitch, TripAdvisor all have high betas (near or above 1.2) because demand for their products usually varies with the business cycle. people tend to indulge in new computers, clothes, and travel when times are good but cut back on these purchases when the economy slows

defensive stocks

stocks of companies which produce products that are typically in demand and have very little relation to the state of the economy ex: Procter & Gamble, shampoo companies, tend to have low betas (near 0.5)

market index

the market value of a broad-based portfolio of securities ex: Dow Jones, S&P 500

The CAPM is mainly used...

to estimate the expected return on stocks and investments within companies; mostly by major corporations to determine the equity cost of capital

By combining stocks into a portfolio, we reduce risk through_______.

By combining stocks into a portfolio, we reduce risk through DIVERSIFICATION - the amount of a stock's risk that is removed by diversification depends on its correlation with other stocks in the portfolio

Expected Return for Investment i equation

Expected Return for Investment i=Risk-Free Rate+βi×Risk Premium per Unit of Systematic Risk (per unit of β).

Expected Return equation

Expected Return= Risk-Free Rate + Risk Premium for Systematic Risk

Investors require a ___________ proportional to the amount of *systematic* risk they are bearing

Investors require a RISK PREMIUM proportional to the amount of *systematic* risk they are bearing

market risk premium (equity risk premium)

The historical average excess returns on the market portfolio. -We know that the market portfolio by definition, has exactly one unit of systematic risk (it has a beta of 1). so a natural estimate of the risk premium per unit of systematic risk the historical average excess return on the market portfolio, also known as the market or equity risk premium

The intuition is that if a stock's returns are highly sensitive to the market portfolio's returns, then that stock is________.

The intuition is that if a stock's returns are highly sensitive to the market portfolio's returns, then that stock is HIGHLY SENSITIVE TO SYSTEMATIC RISK. -events that are systematic and affect the whole market are also strongly reflected in the stock's returns. if a stock's returns do not depend on the market's returns, then it has little systematic risk- when systematic events happen, they are not strongly reflected in its returns. so stocks whose returns are volatile AND are highly correlated with the market's returns are the riskiest in the sense that they have the most systematic risk

market capitalization

The total market value of a firm's equity; equals the market price per share times the number of shares Market Capitalization= (# of shares outstanding) x (price per share)

volatility of a portfolio

The total risk, measured as standard deviation, of a portfolio.

How would you compute the portfolio variance of a two-stock portfolio?

Var= Accounting for the risk of stock 1 + Accounting for the risk of stock 2 + Adjustment for how much the two stocks move together (their correlation) -the equation demonstrates that with a positive amount invested in each stock, the more the stocks move together and the higher their correlation, the more volatile the portfolio will be. the portfolio will have the greatest variance if the stocks have a perfect positive correlation of 1

correlation

a measure of the degree to which returns share common risk. It is calculated as the covariance of the returns divided by the product of the standard deviations of each return -ranges from -1 to 1 -the closer the correlation is to 1 the more the returns tend to move together as a result of common risk -when the correlation equals 0 the returns are uncorrelated (they have no tendency to move together or opposite of one another) -the closer to correlation is to -1 the more the returns tend to move in opposite directions

market proxy

a portfolio whose return should closely track the true market portfolio -While the market portfolio is easy to identify, actually constructing it is a different matter. Because it should contain all risky securities, we need to include all stocks, bonds, real estate, commodities, etc. both in the US and around the world. Clearly, it would be almost impossible to collect & update returns on all risky assets everywhere. So in practice, we use a market proxy- a portfolio whose return should track the underlying, unobservable market portfolio.

Only common, systematic risk determines expected returns, firm-specific risk is diversifiable and does or does not warrant extra return?

does NOT

What is the most common proxy portfolios?

market indexes

In order to compute the cost of equity capital for a company, (which is the best available expected return offered in the market on an investment of comparable risk and term), we need to know the relation between the company's __________ & ________

risk & expected return

The CAPM says that we can compute the expected, or required, return for any investment. Which when its graphed is called the_______.

security market line

Market portfolio only contains what kind of risk?

systematic risk -Any risk that is correlated with the market portfolio must be systematic risk. therefore, by looking at the sensitivity of a stock's return to the overall market, we can calculate the amount of systematic risk the stock has

what is the beta of a portfolio?

the beta of a portfolio is the market value weighted average beta of the securities in the portfolio

What is a security's beta?

the expected percentage change in the return of the security for a 1% change in the return of the market portfolio. that is, beta represents the amount by which risks that affect the overall market are amplified or dampened in a given stock or investment. -securities whose returns tend to move one for one with the market on average have a beta of 1. -securities that tend to move more than the market, have higher betas, while those that move less than the market have lower betas.

required return

the expected return of an investment that is necessary to compensate for the risk of undertaking the investment

market portfolio

the portfolio of all risky investments, held in proportion to their values -Suppose all investors hold portfolios that contain only systematic risk. If that is the case, then consider the portfolio we obtain by combining the portfolios of every investor. Because each investor's portfolio contains only systematic risk, the same is true for this "aggregate" portfolio. So, the aggregate portfolio held by all investors is a fully diversified, optimal portfolio. Moreover, we can identify this portfolio: Because all securities are held by someone, the aggregate portfolio contains all shares outstanding of every risky security. We call this portfolio the market portfolio.

define portfolio weights

the relative investment in your portfolio; the fraction of the total investment in a portfolio held in each individual investment in the portfolio wi= Value of Investment i ÷ Total Value of Portfolio

define expected return of a portfolio

the return you can expect to earn on your portfolio, given the expected returns of the securities in that portfolio and the relative amount you have invested in each; the weighted average of the expected returns of the investments within it, using the portfolio weights: E[Rp]=w1E[R1]+w2E[R2]+...+wnE[Rn]

If you build a large enough portfolio, you can remove all unsystematic risk by diversification, but what risk still remains?

the systematic risk remains

define the return of a portfolio

the total return earned on your portfolio, accounting for the returns of all of the securities in the portfolio and their weights; the weighted average of the returns on the investments in the portfolio, where the weights correspond to the portfolio weights

true or false: the expected return of a portfolio should correspond to the portfolio's beta

true