FIN 331 chapter 8, Chapter 8: Risk and Rates of Return

Rate of return =

(amount received - amount invested)/amount invested

Market Risk Premium

(rM-RRF) - additional return over the risk free rate required to compensate an average investor for assuming an average amount of risk - size of premium depends on how risky investors think market is and their degree of risk aversion

Risk Premium

- additional compensation investors require for a higher risk asset - difference between the expected rate of return on a given risky asset and that on a less risky asset

Security Market Line

- equation that shows relationship between risk as measured by beta and the required rates of return on individual securities -SML= risk free return + (market risk premium)(Stock's beta)

Probability Distributions

- listing of possible outcomes or events with a probability assigned to each outcome

Beta Coefficient

- measures the tendency of a stock to move with the market - measures market risk

Market Risk

- risk that remains in portfolio after diversification has eliminated all company specific risk - known as beta risk - ex. war, inflation, recession, high interest rates

Diversifiable Risk

- that part of a security's risk associated with random events - risk that can be eliminated by adding stocks - ex. lawsuits, strikes, other unsystematic events

The tighter the probability distribution:

- the more likely the actual outcome will be close to the expected value - lower the risk

Coefficient of Variation (CV)

- used to choose between two investments if one has a higher expected return, but the other has a lower standard deviation - standard deviation/ expected rate of return - shows the risk per unit of return

Standard Deviation

- used to quantify the tightness of the probability distribution - measure of how far the actual return is likely to deviate from the expected return

Expected rate of return (r "hat")

- weighted average of the probability distributions of possible results - rate of return expected to be realized from an investment

How to Measure Expected Returns:

-rate of return expected to be realized from an investment - it is the mean value of the probability distribution of possible returns

An averages stock's bets equals:

1

two types of investment risk

1. Stand-Alone Risk 2. Portfolio Risk

Portfolio's total risk can be divided to two parts:

1. diversifiable risk 2. market risk

Asset's risk can be analyzed in two ways:

1. stand-alone risk 2. portfolio basis

Coefficient of Variation (CV)

A standardized measure of dispersion about the expected value, that shows the risk per unit of return CV = Standard deviation/mean return

Risk Return Line

A steeper line suggests that an investor is very adverse to take on risk

Market Risk Premium

Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

Stock Market Equilibrium

Is when the expected return is = the required return.

beta (b)

Measure a stock's market risk, and show a stock's volatility relative to the market. Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

Standard deviation and return...

Measures the risk of an asset. SD & return go hand in hand when comparing risk.

Capital assent pricing model (CAPM)

Model based upon concept that a stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification

riskier the investment when

The greater the chance of lower than expected or negative returns

Primary conclusion

The relevant riskiness a stock is its contribution to the riskiness of a well- diversified portfolio

There are no _______ _________ correlated assets.

There are no perfectly negative correlated assets.

Expected return

_________ of a portfolio is a weighted average of each of the component assets of the portfolio.

A portfolio's risk would decline faster if you chose stocks with ____ correlations with one another and with ________ stand-alone risk

low, low

Portfolio's risk is generally ________ than the average of the stock's standard deviations because of diversification

lower

correlation coefficient

measure of the degree of relationship between two variables

Standard Deviation

measures total, or stand-alone, risk

Perfectly negatively correlated stocks

p=-1 - returns on two stocks with same expected return would move up and down opposite of each other, and reduce risk of portfolio

Perfectly positive correlated stocks

p=1 - returns on two stocks with same expected return would move up and down together and portfolio would be just as risky as holding individual stocks

r =

r = expected rate of return

realized rates of return

returns that were actually earned during some past period

Stand-alone risk

risk an investor would face if he or she held only this one asset

2. Portfolio Risk

risk of an asset held in a group of assets (volatility)

The _______ the standard deviation, the tighter the probability distribution, and accordingly, the lower the risk

smaller

If a company is investing in riskier projects:

it must offer its investors higher expected returns

Any change in the ________ (change in beta or inflation) impacts stock price.

Any change in the required return (change in beta or inflation) impacts stock price.

CAPM/SML concepts

Are based upon expectations, but betas are calculated using historical data

Most stocks are ____ correlated with the market.

Most stocks are positively correlated with the market.

Firm-specific Risk

Portion of security's stand-alone risk that can be eliminated through proper diversification

Market Risk

Portion of security's stand-alone risk that cannot be eliminated through diversification. Measured by beta

Investment Risk

Related to the probability of earning a low or negative actual return

1. Stand-Alone Risk

Risk of an asset held in isolation (Putting all your eggs in one basket) Stand-Alone Risk = Market Risk + Firm specific risk

Dollar return =

amount received - amount invested

larger standard deviation

associated with a wider probability distribution of returns

Risk Aversion

assumes investors dislike risk and require higher rates of return to encourage them to hold risker securities

The beta of a portfolio is the...

average of each of the stock's betas

The market risk of a stock is measured by:

beta coefficient

How can a firm influence the size of its beta?

changes in the composition of its assets and through changes in the amount of debt it uses

On average, portfolio risk ________ as the number of stocks in a portfolio increases, but at a decreasing rate

declines

Slope of SML line reflects:

degree of risk aversion in the economy

Investor's goal

earn returns that are more than sufficient to compensate for the perceived risk of the investment (getting above risk-return trade-off line)

Risk Free Rate of return

generally measured by the return on U.S Treasury securities

Standard deviation is not an appropriate measure of a stock's risk when thinking about portfolio's because:

it includes risk that can be eliminated by holding the stock in a portfolio

Risk Premiums

the difference between the return on risky assets and less risky assets, which serves as compensation for investors to hold riskier securities

No investment should be undertaken unless:

the expected rate of return is high enough to compensate for the perceived risk

the larger the standard deviation

the lower the probability that actual returns will be close to expected returns

If b is = to 1.0,

the security is just as risky as the average stock.

If b is < 1.0,

the security is less risky than average.

If b is > 1.0,

the security is riskier than average.

The greater the stock's volatility:

the steeper the line and the larger its loss in a down market

If b is < 0,

then the correlation between Stock i and the market is negative (i.e., pi,m < 0). Highly unlikely.

The required return of a portfolio is the...

weighted average of each of the stock's required returns.

Expected return on a portfolio (rp "hat")

weighted average of the expected returns of the individual assets in the portfolio, with the weights being the percentage of the total portfolio invested in each asset