Finance 3100 Chapter 8
Slope=
(E(Ri)-Rf)/beta-i
HPR=
(ending price + distributions - beginning price)/beginning price
Capital Asset Pricing Model (CAPM)
E(Ri)=Rf + (E(Rm)-Rf)x Beta-i
Therefore Total return =
Expected return + Systematic portion + Unsystematic portion
There are two types of risks
Systematic and unsystematic
CAPM depends on 3
The amount of systematic risk, as measured by Beta-i, which is the amount of systematic risk present in a particular asset, relative to the market portfolio
Returns or Risk-return trade-off
The goal of each investor is to maximize return and minimize risk at the same time.
CAPM depends on 2
The reward for bearing systematic risk as measure by the market risk premium E(Rm)-Rf
Reward to risk ratio
The slope of the SML is defined as the ______.
The true risk of investment
The unanticipated part of the return, the portion of the announcement resulting in surprise.
Portfolio variance
Unlike the expected return, the variance of a portfolio is not generally equal to the weighted average of the corresponding variance of the individual asset.
Expected return
Using historical data or any kind of information, we may come up with an estimate of the future stock return. This estimate is called the expected return, the actual return may turn out to be higher or lower than our expected return. So, an expected return is a return on a risky asset expected in the future.
Systematic risk
affects a large number of assets and has market wide effect. It is also called Market risk
Unsystematic risk
affects a single asset or a small group of assets. This risk is unique to individual companies or assets and is called Asset-Specific risk
in a well-functioning market, when assets' expected returns are plotted
against assets' betas, all assets plot on the same straight like which is the security market line.
We may have different possible expected returns
based on different outcomes. For example, if we predict that there is a 50% chance that the economy will boom, in that case we may estimate that the expected return on the stock is 70%. However, we may also predict that there is a 50% chance that the economy will enter a recession, and in this our expected return on the stock will be then -20%. In this case, we have two states of the economy, meaning that there are only two possible situations either the economy will boom or the economy will enter a recession.
The linear relationship
between the systematic risk and expected return is described graphically by the Security Market Line (SML).
Systematic risk
cannot be diversified.
Risk premium
compensation that investors require for bearing a risky investment.
Standard deviation of a portfolio
decreases as the number of securities in the portfolio increases. Essentially, some of the riskiness associated with individual assets can be eliminated by forming portfolios.
The SML
describes investor's opportunities in the financial markets in terms of systematic risk and expected return.
Announcement=
expected part + surprise
Total return=
expected return + unexpected return
The market portfolio
has a beta coefficient of 1
An asset with .5 beta coefficient
has half as much systematic risk as the market and its expected return should be lower than that of the market.
Risk free asset
has no systematic risk so it has a zero beta coefficient
An asset with a beta coefficient of 2
has twice as much systematic risk as the market and therefore its expected return should be higher than the expected return on the market.
HPR
holding period return
Portfolio
is a combination of assets such as stocks and bonds held by an investor.
Variance
is a measure of statistical dispersion that indicates how possible values are spread around the expected value.
The beta of a portfolio
is a weighted average of the betas of the securities which comprise the portfolio.
Portfolio standard deviation
is almost always less than the weighted average of the standard deviations of the securities in the portfolio
Asset specific risk
is also known as unsystematic risk.
The minimum expected return available in the financial markets for investment with a specific risk level
is also the shareholders' opportunity cost. Therefore, the minimum required return on a new investment - the amount necessary for the firm to break even - is the firm's cost of capital
Measurement of risk
is based on the size of the differences between actual returns, R, and expected returns, E(R).
Risk that can be eliminated by diversification
is called "diversifiable risk".
The return on any stock in the market
is composed of two parts
The systematic risk of an asset
is measured by its beta coefficient
A rational investor
is more concerned about the characteristics of the portfolio than the characteristics of the individual assets in the portfolio
Only the systematic risk portion
is relevant in determining the expected return.
Cost of capital for a capital budgeting project
is the minimum required return for the investment.
1st part of the return on any stock
is the normal or expected return from the stock. This return depends on the information shareholders have on that stock, example, the expected future cash flows.
Portfolio weight
is the percentage of a portfolio's total value invested in a particular asset.
E(Ri)-Rf
is the risk premium, the difference between the return on asset "i" and the return on the risk free asset. It is the expected return that compensates for bearing the risk
2nd part of the return on any stock
is the uncertain risky part. This is the portion that comes from unexpected return is due to surprises that are reflected in the unexpected return.
2nd component of the announcement
is the unexpected part (surprise). This news will affect the price either positive or negatively because this information was unexpected by the market.
Portfolio expected returns
is the weighted average of the expected returns of the securities which comprise the portfolio
Unsystematic risk of one asset
is unrelated to the systematic risk of another
Diversifiable risk
is unsystematic risk.
A capital budgeting project
must provide an expected return to shareholders that exceeds that available for investments of comparable risk in the financial markets.
Systematic risk is also known as
non-diversifiable risk
Therefore total risk =
non-diversifiable risk + diversifiable risk = systematic risk + unsystematic risk
The square root
of the variance is called the standard deviation.
Diversification
process of combining assets in one portfolio to reduce risk.
CAPM depends on 1
pure time value of money, as measured by the risk-free rate Rf
The market portfolio which includes all assets in the market
should also plot on the SML because market portfolio has a beta of 1.
CAPM
shows that the expected return for a particular asset depends on three things
Systematic risk is the relevant risk for an investor,
so the expected return is dependent only on beta
If you invest in a large portfolio
some of the stocks in the portfolio will go up in value because of positive company-specific events and some will go down in value because of negative events. The net effect on the overall value of the portfolio will be relatively small; these effects will tend to cancel each other out.
Returns can be
stated in terms of dollar amounts or as percentage
The risk of owning an asset comes from
surprises and unanticipated events
Beta measures
the amount of systematic risk for a particular asset relative to the amount of systematic risk for the overall stock market.
Risk premium is also defined as
the difference between the return on a risky investment and that on a risk-free investment.
1st component of an announcement
the expected part is supposed to have no effect on the stock price because in the language of Wall Street, the market already "discounted" (anticipated) the expected part, in other words, that information is already incorporated in the price.
The systematic risk principle states
the expected return on an asset depends only on that asset;s systematic risk.
In a well-functioning market
the reward-to-risk ratio (the slope of the security market line) is the same for every asset.
In a relatively large portfolio
the unsystematic risk can be practically eliminated. Intuitively, the unsystematic risk which is the risk relative to a single asset, has little or no effect on the overall risk of the portfolio.
If you invest in a single stock,
the value of your investment would fluctuate because of company specific events (unsystematic risk)
If we always receive what we expect
then the investment is perfectly predictable and therefore it is risk-free.
Systematic risk is relevant to the expected return is dependent only on beta regardless
to the standard deviation of the asset
Some studies has established that
total diversification can be achieved by having at least 30 stocks in a portfolio
An announcement has
two components.