Finance Ch. 13

Measuring Systematic Risk

Crucial determinant of an assets expected return, we need some way of measuring the level of systematic risk for different investments. -the measure used is called the Beta Coefficient. (B) -How much systematic risk a particular asset has relative relative to an average asset. -beta of .5 means an asset has half as much systematic risk as an average asset. beta of 2 means it has twice as much. -Because assets with larger betas will have more systematic risk they will greater expected returns.

Portfolio Betas

If we had many assets in a portfolio, we would multiply each assets beta by its portfolio weight and then add the results to get the portfolios beta. -putting half of money in google and half in pepsi calculating Beta would be B=.5(B-google) + .5(B-pepsi)

Expected and Unexpected Returns

The return on any stock traded in market depends on two parts. 1. the normal or expected return from the stock is the part of the return that shareholders in the market predict or expect. 2. The second part of the return on the stock is the uncertain or risky part. This is the result of unexpected information that is revealed within the year. Total Return=Expected ReturnE(R)+Unexpected Return. -If for example GDP effects the value of flyers stock, the E(R) is considered to be the forecasted information about GDP but any new information that may have a positive or negative effect would be Unexpected Return (U) in the equation. (The unanticipated portion of return) -The unanticipated part of the return, that portion resulting from surprises, is the true risk of any investment. -The risk of owning an asset comes from surprises-unanticipated events.

Market Risk Premium

The slope of the SML - the difference between expected return on a market portfolio and the risk free rate. -E(R)-(R) or expected market return - risk free rate/ market Beta. -

Capital Asset Pricing Model

(CAPM) The equation of the SML showing the relationship between expected return and beta. Expected return(i) = risk free rate + [expected market return-risk free rate] x Beta(i) -Shows that expected return depends on three things 1. the pure time value of money, as measured by the risk free rate R(f), this is the reward for merely waiting for your money without taking any risk. 2. The reward for bearing systematic risk, as measure by E(Rm)-R(f), this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting. 3. The amount of systematic risk, as measure by B(i), this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset.

Diversification and Unsystematic Risk

-If we held only a single stock, the value of our investment would fluctuate because of company specific events. -If we held a large portfolio, some of the stocks in the portfolio would 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, however, because these effects will tend to cancel each other out. -Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.

Portfolio

A group of assets such as stocks and bonds held by an investor.

Security Market Line (SML)

A positively sloped straight line displaying the relationship between expected return and beta. -Used to describe the relationship between systematic risk and expected return in financial markets. -Arguably most important concept in finance after NPV. -Risk free assets have a beta of 0. -Percentages in investments can exceed 100% if they borrow money. -borrowing an additional amount for a certain percentage increased expected return and increases Beta. -

Unsystematic Risk

A risk that affects a single asset or a small group of assets. -Unique to individual companies or assets. (also called Unique or asset-specific risks) -When a companies workers go on strike this affects primarily that company and possibly its suppliers or competitors. It will not affect the world market.

Systematic Risk

A risk that influences a large number of assets, each to a greater or lesser extent also called market risk. -Uncertainties about general economic conditions (GDP, Interest rates). -affect nearly all companies to some degree.

Systematic and Unsystematic Components of Returns

Breaking down the surprise portion (U) of the equation into systematic and unsystematic portions. R= E(R) + U(Unsystematic and systematic) -Unsystematic=greek letter e -systematic= m -R=E(R) + m + e

Diversification and Systematic Risk

Cannot be eliminated by diversification. -a systematic risk affects almost all assets to some degree, systematic risk does not vary based upon the number of assets in a portfolio. -Considered to be the non-diversifiable risk.

Reward to Risk-Ratio

Page 261 -slope of our line (ratio) is the risk premium on our asset E(R) - Risk free rate/Beta. -In other words our asset has a risk premium of .... percent per unit of systematic risk. -due to the fact that people may be attracted to one stock more than another yields a contrasting result. As people purchase more of one asset it decreases the return and when another asset is purchased less it results in an increasing return. Fundamental relationship between risk and return. -They will eventually equal out as other people start buying more of the asset with growing return and less of the asset with dwindling return. -The reward to risk ratio must be the same for all the assets in the market.

Principle of Diversification

Spreading an investment across a number of assets will eliminate some, but not all, of the risk. -some of the riskiness associated with individual assets can be eliminated by forming portfolios. -Non-diversifiable risk is the minimum level of risk that cannot be eliminated. -diversification reduces risk nut only to a certain point.

Beta Coefficient

The amount of systematic risk present in a particular risky asset relative to that in an average risky asset.

Systematic Risk Principle

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

Portfolio Weight

The percentage of a portfolios total value that is invested in a particular asset. -combining assets into a portfolio can substantially alter the risks faced by investors.

Expected Return

The return on a risky asset expected in the future. -projected or expected risk premium is the difference between the expected return on a risky investment and the certain return on a risk free investment. -Expected return on a security or other asset is simply equal to the sum of the possible returns multiplied by their probabilities. -Risk premium would then be the the difference between this expected return and the risk-free rate.