Ch 6

Investor's Required Rate of Return

(RRR) is the minimum rate of return necessary to attract an investor to purchase or hold a security. this definition considers the oppertunity cost of funds, i.e., the forgone return on the next best investment Investor's RRR= risk-free rate of return + risk premium

Capital Asset Model (CAPM)

CAPM equation equates the expected rate of return on stock to the risk-free rate plus a risk premium for the systematic risk CAPM provides for an intuitive approach for thinking about the return that an investor should require on an investment, given the asset's systematic or market risk

Beta

The slope of the line, frequently called beta, measures the average relationship between a stock's returns & those of the S&P 500 index return. Measures the firm's market risk Beta is the risk that remains for a company even after we have diversified our portfolio 1. a stock with a Beta fo 0 has no systematic risk 2. a stock with a Beta of 1 has a systematic risk equal to the "typical" stock in the marketplace. 3. a stock with a Beta exceeding 1 has systematic risk greater than the "typical" stock most stocks have betas between 0.60 and 1.60. NOTE, the value of beta is highly dependent on the methodology & data used.

Risk and Diversification

Total risk of portfolio is due to 2 types of risk: 1. Systematic (or market risk): is risk that affects all firms (e.g. tax rate changes, war) 2. Unsystematic (or company-unique risk): is risk that affects only a specific firm (e.g. labor strikes, CEO change) Only unsystematic risk can be reduced or eliminated through effective diversification

Risk (measured)

consider two investment options: 1. invest in Treasury bond that offers a 2% annual return 2. Invest in stock of a local publishing company with a n expected return of 14 % based on the payoffs

Risk Premium

in the additional return we must expect to receive for assuming risk

Standard Deviation

is one way to measure risk. it measures the volatility or riskiness of portfolio returns. = square root of the weighted average squared deviation of each possible return from the expected return. 1. risk is relative to get the full picture 2. we need to consider not only the standard deviation but also the expected return 3. the choice of a particular investment depends on the investors attitude toward risk

Risk-Free Rate & Risk Premium

is the required of return or discount rate fro risk-free investments. is typically measured by the U.S. Treasury bill rate

Holding-Period Return

payoff during the "holding" period. holding period could be any unit of time. Historical or realized rate of return

Portfolio

refers to combining several assets ex. investing in multiple financial assets (stocks, bonds, t-bills). Investing in multiple items from a single market (e.g. investing in 30 different stocks)

Risk (defined)

refers to potential variability in future cash flows. The wider the range of possible future events that can occur the greater risk. Thus, the returns on common stock are more risky than returns from investing in a savings account in a bank

Expected Return

the expected benefits or returns an investment generates come in the form of cash flows. Cash flows are used to measure returns (not accounting profits) Expected return is the weighted average all the possible returns, weighted by the probability that each return will occur.

Characteristic Line

the line of "best fit" through a series of returns for a firm's stock relative to the market's returns.

Correlation and Risk Reduction

the main motive for holding multiple assets or creating a portfolio of stocks (called Diversification) is to reduce the overall risk exposure. the degree of reduction depends on the correlation among the assets. if 2 stocks are perfectly positively correlated, diversification has no effect on risk. if 2 stocks are perfectly negatively correlated, the portfolio is perfectly diversified while building a portfolio, we should pick securities/ assets that have negative or low positive correlation to realize diversification benefits.

Asset Allocation

the market rewards diversification. Through effective diversification 1. we can lower risk without sacrificing expected returns 2. we can increase expected returns without having to assume more risk asset allocation refers to diversifying among different kinds of asset types such as treasury bills, corporate bonds, commons stocks asset allocation is considered the "most important decision" while managing an investment portfolio.

Portfolio Beta

the percentage change on average of the portfolio for ever 1% change in the general market

as the level of risk increases

we will demand additional expected returns