Chapter 11; Risk and Return

a common way of saying that an announcement isn't news is to say that the market has already

"discounted" the announcement when we discount a dollar in the future, we say it is worth less to us because of the time value of money when we say that we discount an announcement, or a news item, we mean that it has less of an impact on the market because the market already knew much of it

similarly the beta on portfolio Bp would be:

Bp = .25 X BA + (1 - .25) X 0 = .25 X 1.6 = . 40 ***notice that, because the weights have to ad d

if 25 percent of the portfolio is invested in Asset A, then the expected return is:

E(Rp) = .25 X E(RA) + (1 - .25) X Rf =.25 X 20% + .75 X 8% =11%

principle of diversification has an important implication:

To a diversified investor, only systematic risk matters it follows that in deciding whether or not buy a particular individual asset, a diversified investor will only be concerned with that asset's systematic risk

one way to express the return of Flyers's stock in the coming year would be:

Total return = expected return + Unexpected return R = E(R) + U`

example: to see how risk is rewarded in the marketplace to begin, suppose that Asset A has an expected return of E(Ra) = 20% and a beta Ba = 1.6. Furthermore, the risk-free rate is Rf = 8%. Notice that a risk-free asset, by definition, has no systematic risk (or unsystematic risk, for that matter), so

a risk-free asset has a beta of 0.

systematic risk affects

almost all assets in the economy, at least to some degree, while unsystematic risk affects at most a small number of assets

an announcement, then, can be broken into two parts, the anticipated, or expected, part and the surprise, or innovation:

announcement = expected part + surprise

an unsystematic risk is one that affects a single

assets or a small group small group of assets because these risks are unique to individual companies assets, they are sometimes called unique or asset-specific risks

to develop SML (security market line) we introduce the

equally famous "beta" coefficient, one of the centerpieces of modern finance Beta and the SML are key concepts because they supply us with at least part of the answer to the question of how to go about determining the required return on investment

we need to expand our consideration to include individual assets ; we have two tasks to accomplish

first, we have to define risk and then discuss how to measure it we then must quantify the relationship between an asset's risk and its required

The return on any stock traded in a financial market is composed of two parts

first, the normal or expected, return from the stock is the part of the return that shareholders in the market predict or expect this return depends on the information shareholders have the bears on the stock, and it is based on the market's understanding today of the important factors that will influence the stock in the coming year the second part of the return on the stock is the uncertain, or risky, part This is the portion that comes from unexpected information revealed within the year.

the risk premium is larger

for riskier investments

the difference between the actual result and the forecast, one percentage point is sometimes called the

innovation or the surprise

systematic risk is also called

nondiversifiable risk or market risk

risk premium equation

risk premium = expected return - risk free rate

there are two types of risk:

systematic and unsystematic

a beta coefficient, or beta for short, tells us how much

systematic risk a particular asset has relative to itself an asset with a beta of .5 therefore, has half as much systematic risk as an average asset; an asset with a beta of 2.0 has twice as much

using our projected returns, we can calculate the projected or expected, risk premium as

the difference between the expected return on a risky investment and the certain return on a risk-free investment

risk premium

the difference between the return on a risky investment and that on a risk-free investment, and we calculated the historical risk premiums on some different investments

systematic risk principle states that

the reward for bearing risk depends only on the systematic risk of an investment the underlying rationale for this principle is straightforward: because unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward for bearing it

because systematic risk is the crucial determinant of an asset's expected return, we need some way of measuring the level of systematic risk for different investment

the specific measure we will use is called the beta coefficient

the unanticipated part of the return, that portion resulting from surprises, is

the true risk of any investment the risk of owning an asset comes from surprises- unanticipated events

risk premium

there is a reward, on average, for bearing risk

total risk of investment:

total risk = systematic risk + unsystematic risk

the first type of surprise we will call

unsystematic risk

two states of the economy

which means that these are the only two possible situations

diversification

which shows that highly diversified portfolio will tend to have almost no unsystematic risk