Finance 3150 - Chapter 11 - Risk and Return
Expected return calculation. Expected return Stock A: 10%, Stock B: 15%. Assume you're equally invested in both stocks.
.5 x 10% + .5 x 15% = 12.5%
The 4 steps of the computation of variance
1. Calculate the expected return. 2. Calculate the deviation of each return from the expected return. 3. Square each deviation. 4. Calculate the average squared deviation.
Announcement
2 parts. Announcement = expected part (E(R), return of the stock) + surprise (innovation) (U-unanticipated return on the stock)
Beta coefficient
Amount of the systematic risk present in a particular risky asset relative to that in an average risky asset.
CAPM
Capital asset pricing model
As the number of securities in a portfolio increases, the standard deviation of returns for the portfolio
Declines
Unsystematic risk
Is one that affects a single asset or a small group of assets. Unique to individual companies or assets (aka unique or asset-specific risks).
An investment will have a negative NPV when its expected return is ___________ __________ what the financial market offer for the same risk.
Less than
SML Slope
Market risk premium
Standard deviation? State: Boom, Probability: .25, Portfolio Return: 10% State: Normal, Probability: .5, Portfolio Return: 4% State: Bust, Probability: .25, Portfolio Return: -6%
Mean return = .25*.1 + .5*.04 + .25*-.06 = .03 Standard deviation = [.25*(.1-.03)^2 + .5*(.04-.03)^2 + .25*(-.06-.03)^2]^.5 = .0574
Cost of capital
Minimum required return of a new project.
A portfolio beta can be calculated just like a
Portfolio expected return
The CAPM requirements can be used for individual securities as well as for
Portfolios
Portfolio of assets
Refers to the fact that investors tend to own more than just a single stock, bond, or other asset.
Expected return
Return on a risky asset expected in the future.
Reward-to-Risk Ratio
Slope = E(Ra)-R1/Ba
Standard deviation
Square root of the variance.
Systematic risk principle
States that the reward for bearing risk depends only on the systematic risk of an investment. Because unsystematic risk is easy to eliminate by diversifying there is no reward for hearing it.
________________ risk is the only risk important to the well diversified investor.
Systematic
A security has a beta of 1, a market risk premium of 8%, and a risk-free rate of 3%. What will happen to the expected return if the beta doubles?
The expected return will increase to 19% from 11%. Old expected return = 3% + 1 x 8% = 11% New expected return = 3% + 2 x 8% = 19%
Security Market Line (SML)
The line that is used to describe the relationship between systematic risk and expected return in financial markets. It's a graphical depiction of the capital asset pricing model.
According to CAPM, what is the expected return on a security with a beta of zero?
The risk-free rate of return.
What does variance measure?
The spread of the sample of returns. Also measures the riskiness of a securitys returns.
As more securities are added to a portfolio.
The unsystematic risk is likely to decrease and eventually be almost totally eliminated. Also reduced is the company-specific and diversifiable able risks.
How are the unsystematic risks of two different companies in two different industries related?
There is no relationship.
2 factors that determine a stock's total return?
Total return = expected return + unexpected return or R = E(R) + U R stands for the actual total return in the year, E(R) stands for the expected part of the return and U stand for the unexpected part of the return.
Systematic risk
Type of surprise. Affects a large number of assets. Market wide affects (aka market risks).
Information that may impact the risky return of a stock includes.
Unexpected information revealed in the year.
Beta of a risk free asset is?
Zero
Risk premium
the difference between the return on a risky investment and that on a risk-free investment.