Business Finance Ch 2

If a portfolio's standards deviation is less than the weighted average of the individual stock's standard deviations, then...

diversification provides a benefit.

1. What is diversification effect?

Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.

total risk

Stand-alone risk is the risk of each asset held by itself. one asset. Standard deviation measures the dispersion of possible outcomes. For a single asset: Stand-alone risk = Standard deviation

What does correlation coefficient measure?

The tendency of two variables to move together is called correlation, and the correlation coefficient measures this tendency. It can range from +1.0 to denoting that the two variables move up and down in a perfect synchronization, to -1.0 denoting that the two variables always move in exactly opposite direction.

How to measure stand alone risk?

You can measure stand alone risk by standard deviation. A large standard deviation means that possible outcomes are widely dispersed whereas a small SD means that outcomes are more tightly clustered around the expected value. It provides an idea of how far above or below the expected value is likely to be.

What is CAPM Model

defines the relevant risk of an individual assets as its contribution to the risk of a well-diversified portfolio.

For any other correlation then

diversification reduces but cannot eliminate risk: for between -1 and +1 the portfolio the portfolio's standard deviation is less than the weighted average of the stocks' standard deviation.

What are possible impacts on SML if inflation rate fluctuates and/or market risk premium changes?

if inflation rates go up a change in r(RF) changes so will the required return on the market and this will other things held constant keep the market risk premium stable. Therefore the whole line will go up as well. (draw the graph or look at page 64). if market risk premium changes then the slope of the line of the graph changes because it is determined on whether an investor is more risk adverse or not. the steeper the slope the more risk averse they are. (pg. 65).

diversifiable risk

is caused by such random events such as lawsuits, strikes, successful and unsuccessful marketing programs, winning or loosing major contract, and other events that are unique to the firm. because these events are random, you can eliminate with diversification.

market risk

stems from factors that systematically affect most firms: war, inflation, recessions, and high interest rates. The market rate cannot be eliminated by diversification.

if the correlation is +1 then (highest possible correlation)

the portfolio's standard deviation would be the weighted average of the stock's standard deviation. In this case, diversification doesn't help. for +1 the portfolio standard is the weighted average of the stock's standard deviations

if two stocks have a correlation of -1 (the lowest possible correlation)

when one stock has a higher than expected then the other stock has a lower than expected return, and vice versa. for correlation that is -1 the portfolio's standard deviation can be as low as zero if the portfolio weights are chosen appropriately.