Finance 3100 Chapter 8

Slope=

(E(Ri)-Rf)/beta-i

HPR=

(ending price + distributions - beginning price)/beginning price

Capital Asset Pricing Model (CAPM)

E(Ri)=Rf + (E(Rm)-Rf)x Beta-i

Therefore Total return =

Expected return + Systematic portion + Unsystematic portion

There are two types of risks

Systematic and unsystematic

CAPM depends on 3

The amount of systematic risk, as measured by Beta-i, which is the amount of systematic risk present in a particular asset, relative to the market portfolio

Returns or Risk-return trade-off

The goal of each investor is to maximize return and minimize risk at the same time.

CAPM depends on 2

The reward for bearing systematic risk as measure by the market risk premium E(Rm)-Rf

Reward to risk ratio

The slope of the SML is defined as the ______.

The true risk of investment

The unanticipated part of the return, the portion of the announcement resulting in surprise.

Portfolio variance

Unlike the expected return, the variance of a portfolio is not generally equal to the weighted average of the corresponding variance of the individual asset.

Expected return

Using historical data or any kind of information, we may come up with an estimate of the future stock return. This estimate is called the expected return, the actual return may turn out to be higher or lower than our expected return. So, an expected return is a return on a risky asset expected in the future.

Systematic risk

affects a large number of assets and has market wide effect. It is also called Market risk

Unsystematic risk

affects a single asset or a small group of assets. This risk is unique to individual companies or assets and is called Asset-Specific risk

in a well-functioning market, when assets' expected returns are plotted

against assets' betas, all assets plot on the same straight like which is the security market line.

We may have different possible expected returns

based on different outcomes. For example, if we predict that there is a 50% chance that the economy will boom, in that case we may estimate that the expected return on the stock is 70%. However, we may also predict that there is a 50% chance that the economy will enter a recession, and in this our expected return on the stock will be then -20%. In this case, we have two states of the economy, meaning that there are only two possible situations either the economy will boom or the economy will enter a recession.

The linear relationship

between the systematic risk and expected return is described graphically by the Security Market Line (SML).

Systematic risk

cannot be diversified.

Risk premium

compensation that investors require for bearing a risky investment.

Standard deviation of a portfolio

decreases as the number of securities in the portfolio increases. Essentially, some of the riskiness associated with individual assets can be eliminated by forming portfolios.

The SML

describes investor's opportunities in the financial markets in terms of systematic risk and expected return.

Announcement=

expected part + surprise

Total return=

expected return + unexpected return

The market portfolio

has a beta coefficient of 1

An asset with .5 beta coefficient

has half as much systematic risk as the market and its expected return should be lower than that of the market.

Risk free asset

has no systematic risk so it has a zero beta coefficient

An asset with a beta coefficient of 2

has twice as much systematic risk as the market and therefore its expected return should be higher than the expected return on the market.

HPR

holding period return

Portfolio

is a combination of assets such as stocks and bonds held by an investor.

Variance

is a measure of statistical dispersion that indicates how possible values are spread around the expected value.

The beta of a portfolio

is a weighted average of the betas of the securities which comprise the portfolio.

Portfolio standard deviation

is almost always less than the weighted average of the standard deviations of the securities in the portfolio

Asset specific risk

is also known as unsystematic risk.

The minimum expected return available in the financial markets for investment with a specific risk level

is also the shareholders' opportunity cost. Therefore, the minimum required return on a new investment - the amount necessary for the firm to break even - is the firm's cost of capital

Measurement of risk

is based on the size of the differences between actual returns, R, and expected returns, E(R).

Risk that can be eliminated by diversification

is called "diversifiable risk".

The return on any stock in the market

is composed of two parts

The systematic risk of an asset

is measured by its beta coefficient

A rational investor

is more concerned about the characteristics of the portfolio than the characteristics of the individual assets in the portfolio

Only the systematic risk portion

is relevant in determining the expected return.

Cost of capital for a capital budgeting project

is the minimum required return for the investment.

1st part of the return on any stock

is the normal or expected return from the stock. This return depends on the information shareholders have on that stock, example, the expected future cash flows.

Portfolio weight

is the percentage of a portfolio's total value invested in a particular asset.

E(Ri)-Rf

is the risk premium, the difference between the return on asset "i" and the return on the risk free asset. It is the expected return that compensates for bearing the risk

2nd part of the return on any stock

is the uncertain risky part. This is the portion that comes from unexpected return is due to surprises that are reflected in the unexpected return.

2nd component of the announcement

is the unexpected part (surprise). This news will affect the price either positive or negatively because this information was unexpected by the market.

Portfolio expected returns

is the weighted average of the expected returns of the securities which comprise the portfolio

Unsystematic risk of one asset

is unrelated to the systematic risk of another

Diversifiable risk

is unsystematic risk.

A capital budgeting project

must provide an expected return to shareholders that exceeds that available for investments of comparable risk in the financial markets.

Systematic risk is also known as

non-diversifiable risk

Therefore total risk =

non-diversifiable risk + diversifiable risk = systematic risk + unsystematic risk

The square root

of the variance is called the standard deviation.

Diversification

process of combining assets in one portfolio to reduce risk.

CAPM depends on 1

pure time value of money, as measured by the risk-free rate Rf

The market portfolio which includes all assets in the market

should also plot on the SML because market portfolio has a beta of 1.

CAPM

shows that the expected return for a particular asset depends on three things

Systematic risk is the relevant risk for an investor,

so the expected return is dependent only on beta

If you invest in a large portfolio

some of the stocks in the portfolio will go up in value because of positive company-specific events and some will go down in value because of negative events. The net effect on the overall value of the portfolio will be relatively small; these effects will tend to cancel each other out.

Returns can be

stated in terms of dollar amounts or as percentage

The risk of owning an asset comes from

surprises and unanticipated events

Beta measures

the amount of systematic risk for a particular asset relative to the amount of systematic risk for the overall stock market.

Risk premium is also defined as

the difference between the return on a risky investment and that on a risk-free investment.

1st component of an announcement

the expected part is supposed to have no effect on the stock price because in the language of Wall Street, the market already "discounted" (anticipated) the expected part, in other words, that information is already incorporated in the price.

The systematic risk principle states

the expected return on an asset depends only on that asset;s systematic risk.

In a well-functioning market

the reward-to-risk ratio (the slope of the security market line) is the same for every asset.

In a relatively large portfolio

the unsystematic risk can be practically eliminated. Intuitively, the unsystematic risk which is the risk relative to a single asset, has little or no effect on the overall risk of the portfolio.

If you invest in a single stock,

the value of your investment would fluctuate because of company specific events (unsystematic risk)

If we always receive what we expect

then the investment is perfectly predictable and therefore it is risk-free.

Systematic risk is relevant to the expected return is dependent only on beta regardless

to the standard deviation of the asset

Some studies has established that

total diversification can be achieved by having at least 30 stocks in a portfolio

An announcement has

two components.