Finance Chapter 8- Risk and Rates of Return

Steep Line

suggests that an investor is very averse to taking on risk, whereas a flatter line would suggest that the investor is more comfortable bearing risk.

Average Stocks Beta

By definition, ba=1 because an average risk stock is one that tends to move up and down in step with the general market.B=.5 the stock is only half as volatile or risky and an average stock. b=2.0 is stock is twice as risky as an average stock.

Probability Distribution

Listing of possible outcomes or events with a probability (chance of occurance) assigned to each outcome. Returns are relatively high when demand is strong and low when demand is weak. The tighter or more peaked the probability distributions the more likely the actual outcome will be close to the expected value adn conseuwntly the less likely the actual return will end up far below the expected return. The tighter the probablity distribution, the lower the risk.

Realized Rates of Return

Returns that were actually earned during some past period. Actual returns tend to be different from expected returns except for riskless assets.

Risk Aversion

Risk averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities. Other things held constant, the higher a security's risk the higher its required return, and if the situation does not hold prices will change to bring out the required condition.

Diversifiable Risk

That part of a security's risk associated with random events ie lawsuits/strikes; it can be eliminated by proper diversification. This risk is also known as company specific, or unsystematic risk. A portfolio's risk declines as stocks are added but at a decreasing rate, and once 40 to 50 stocks are in a portfolio additional stocks do little to reduce risk.

Portfolio Risk

The portfolio risk is generally smaller than the average of the stocks standard deviations because diversification lowers the portfolios risk.

Stand Alone Risk

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

Market Risk

The risk that remains in a portfolio after diversification has eliminated all company specific risk. This risk is also known as non diversifiable or systematic beta risk. Because most stocks are affected by macro factors, market risk cannot be eliminated by diversification.

Relevant Risk

The risk that remains once a stock in a diversified portfolio is its contribution to the portfolios market risk. It is measured by the extent to which the stock moves up or down with the market.

Standard Deviation

The smaller the standard deviation, the tighter the probability distribution and the lower the risk. Standard deviation is a statistical measure of the variability of a set of observations. Mui= sq root(ri-r)^2P. Because past results are often repeated in the future, the historical standard deviation is often used as an estimate of future risk.

Correlation

The tendency of two variables to move together.

Risk of an asset

based on an assets cash flows

Expected Rate of Return

r=P1r1+P2R2+...+PnRn. The rate of return expected to be realized from an investment, the weighted average of the probability of distribution of possible results.

risk free rate

the price of money to a risk less borrower. This is also measured by the rate as measured by the rate on US treasury securities is called the nominal or quoted rate and consists of two elements: the real inflation free rate of return r* and the inflation premium IP equal to the anticipated rate of inflation.

Correlation Coefficient

A measure of the degree of relationship between two variables. In statistical terms we say that returns are perfectly negatively correlated with p=-1.0, perfectly positively correlated with p=+1.0 and if returns are not related to each other at all, they are said to be independent and p=0. If returns on two perfectly positively correlated stocks with the same expected return would move up and down together and a portfolio consisting of these stocks would be exactly as risky as the individual stocks. Diversification is completely useless for reducing risk if the stocks in the portfolio are perfectly positively correlated. Past studies have estimated that on average, the correlation coefficient between the returns of two randomly selected stocks is about 0.30. Under this condition, combining stocks into portfolios reduces risk but does not completely eliminate it.

Beta Coefficient

A metric that shows the extent to which a given stocks returns move up and down with the stock market. Beta measures market risk. The slope of the lines are the stocks beta coefficients. The steeper the line the greater the stocks volatility and thus the larger its loss in a down market. An average stocks beta=1.

Capital Asset Pricing Model

A model based on the proposition that any stocks required rate of return is equal to the risk free rate of return plus a risk premium that reflects only the risk remaining after diversification. The risk of a stock held in a portfolio is typically lower than the stocks risk when it is held alone. What is important is the return on the portfolio and the portfolios risk. When the risk and return of an individual stock should be analyzed it should be in terms of how the security affects the risk and return of the portfolio in which it is held.

Market Portfolio

A portfolio consisting of all stocks. Choose a market portfolio for several reasons: high administrative costs and commissions would more than offset the benefits for individual investors, index funds can be used by investors fro diversification and many individuals can and do get broad diversification through these funds.

Security Market Line (SML) Equation

An equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. req return=risk free rate+ (market risk premium)(stocks l beta). For the SML line, required rates of return on shown on the vertical axis and risk as measured by beta is shown on the horizontal axis. The slope of the SML can be found using the rise or run procedure. A 1 unit increase in beta causes a __% increase in the required rate of return. The slope of the SML reflects the degree of risk aversion in the economy- the greater the average investors risk aversion (a) the steeper the slope of the line and (b) the greater the risk premium for all stocks, hence, the higher the required rate of return on all stocks. the steeper the slope the more the average investor requires as compensation for bearing risk.

Market Risk Premium

The additional return over the risk free rate needed to compromise investors for assuming an average amount of risk. often based off historical data to estimate the market risk premium. RP=Rm-Rfr

Risk

The chance that some unfavorable event will occur. Firms invest funds today with the expectation of receiving additional funds in the future.Bonds offer relatively low returns, but with realtively little risk.

Risk Premium

The difference between the expected rate of return on a given risky asset and that on a less risky asset. This represents the additional compensation investors require for bearing higher risk.

Coefficient of Variation

The standardized measure of the risk per unit of return, calculated as the standard deviation divided by the expected return. The coefficient of variation shows the r risk per unit of return, and it provides more meaningful risk measure when the expected returns on two alternatives are not the same

Expected Return on the Portfolio

The 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. The expected return on a portfolio is a weighted average of expected returns on the stocks in the portfolio.