Ch 8

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as

"company-specific" or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate that is required to compensate stock investors for assuming an

average amount of risk.

Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to

be less risky.

Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A' portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with

beta = 1.0.

A firm can change its beta through managerial decisions, including capital budgeting and

capital structure decisions.

If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to

continue in the future.

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in

ex ante (future) data.

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors'risk aversion, then the market risk premium (r M − r RF ) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in

expected inflation.

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of

investments' stand-alone risk.

Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than

investors who have more tolerance for risk.

If the returns of two firms are negatively correlated, then one of them must have a

negative beta.

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is

negative.

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will

reduce the portfolio's risk.

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are

risk averse.

Most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets. The relevant risk of each asset should be measured in terms of its effect on the

risk of the firm's stockholders.

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the

risk per unit of expected return.

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the

risk-free rate.

Diversification will normally reduce the

riskiness of a portfolio of stocks.

13. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the

riskiness of a well-diversified portfolio.

​Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its

square root, the standard deviation.

The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the

steeper the SML.

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the

stock's price, other things held constant.

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater

than 1.0.

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with

the lower standard deviation.

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant

under the CAPM.