Expected
Return
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Given
all possible outcomes for a particular investment, the average rate of
return is called the expected return. The actual return can differ
from the expected return. In turn the expected risk premium is
the expected return less the risk-free rate. The expected return on a
security is simply equal to the sum of the ____ multiplied by their _____. CONCEPT CHECK
Calculating
the Variance
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Variance is a measure of the dispersion
of the possible outcomes around the expected return. Mathematically,
the variance is the weighted average of the squared deviations around
the mean. The standard
deviation (KEY TERM) is the square root of the variance.
Portfolio
Weights are defined as the percentages of a portfolio's value invested
in the respective portfolio assets.
Portfolio
Expected Returns
(53.0K)
The portfolio expected return is simply
the weighted average of the expected returns of the components of the
portfolio. Joe has $10,000 to invest. He invests $6,000 in Gazoo.com
(with an expected return of 18%) and $4,000 in Bankrupt.com (with an
expected return of 9%). The portfolio expected return is _____. CONCEPT CHECK
Portfolio
Variance
(53.0K)
Portfolio variance is generally not equal
to the weighted average of the variances of the portfolio components;
rather it is a function of the component variances and there relationships
to one another. And of course, the portfolio standard deviation is
the square root of the portfolio variance.
Announcements,
Surprises, and Expected Returns
Expected
and Unexpected Returns
(51.0K)
The return on any stock is composed
of two parts: the normal, or expected part, that investors expect, and
the unexpected part, which is attributable to events and information
that come as a surprise to investors. The total return = _____ + _____. CONCEPT CHECK
Announcements
and News
(52.0K)
"News" is informationthat
comes as a surprise to investors and, therefore, results in a change
in the market price of the stock. An announcement can contain both an
expected part and a news, or surprise, part.
Risk:
Systematic and Unsystematic
Systematic
and Unsystematic Risk Systematic
risk
(51.0K)
affects a large number of assets. Systematic risk is also
referred to as market
risk or nondiversifiable (KEY TERM) risk. Unsystematic
risk
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, on the other hand, is a source of risk that affects a
single asset or a small group of assets. Unsystematic risks are sometimes unique
or firm-specific (KEY TERM) risks. An unexpected upward jump in interest
rates is an example of a(n) _____ risk, while the death of a CEO in a plane
crash is a(n) _____ risk. CONCEPT CHECK
Systematic
and Unsystematic Components of Return Previously we subdivided actual
return into its expected and unexpected ("surprise") components;
i.e., R = E(R) + U. Now we recognize that the surprise component has two
parts: a systematic portion and an unsystematic portion. Thus, R = E(R)
+ Systematic portion + Unsystematic portion.
Diversification
and Portfolio Risk
The
Effect of Diversification: Another Lesson from Market History The empirical
evidence is clear: on average, the standard deviation of a portfolio of
securities declines as the number of securities in the portfolio increases.
The
Principle of Diversification
(52.0K)
Diversification is
the process of spreading an investment across assets. The principle
of diversification tells us that spreading an investment across assets
will eliminate some, but not all, of the risk of the portfolio.
Diversification
and Unsystematic Risk The portion of risk that can be eliminated by
diversification is the unsystematic portion, or the diversifiable
portion
(51.0K)
, of total risk.
Diversification
and Systematic Risk Systematic risks affect large groups of assets
(remember the interest rate example earlier?) and, as a result, cannot be
diversified away. Thus, total
risk
(51.0K)
has two pieces: a systematic piece, and an unsystematic
piece.
Systematic
Risk and Beta
The
Systematic Risk Principle Investors like returns and don't like risks;
thus, they will diversify away as much risk as possible. In the aggregate,
this suggests that only systematic risk will be rewarded in the financial
markets. This is the systematic
risk principle (KEY TERM).
Measuring
Systematic Risk
(52.0K)
The amount of systematic risk an asset
has relative to the average level of risk is indicated by its b ("beta") coefficient.
The average beta for the market is 1.00, and the beta of a risk-free
asset is zero. Suppose you determine that Jet-Electro.com has a beta
of 1.75. This indicates that it has _____ times as much _____ risk as
the average stock. CONCEPT CHECK
Portfolio
Betas Computing
a portfolio beta
(52.0K)
is a lot like computing its expected return:
the portfolio beta is just the weighted average of the betas of the portfolio's
components. The weights, in turn, represent the percentage of the portfolio
invested in a given asset.
The
Security Market Line
Beta
and the Risk Premium
(52.0K)
The risk premium associated with
a particular asset is a positive linear function of that asset's systematic
risk, which, in turn, is measured by its beta.
The
Reward-to-Risk Ratio
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Figure 11.2A suggests that the reward-to-risk
ratio for a risky asset is simply the slope of the line on a graph where
expected return is measured on the vertical axis, and systematic risk is
measured on the horizontal axis.
The
Basic Argument Rational investors will always seek the best reward-to-risk
ratio.
The
Fundamental Result In equilibrium, the actions of investors seeking the best
reward-to-risk ratio will drive the market to equilibrium
(53.0K)
: the reward-to-risk ratio will be the same for all assets in
the market.
The
Security Market Line The relationship between systematic risk and expected
return is depicted by the Security
Market Line
(53.0K)
or SML.
Market
Portfolios The slope of the SML is equal to the Market
Risk Premium (KEY TERM), or MRP.
The
Capital Asset Pricing Model
(52.0K)
or "CAPM" is the equation
for the SML. Specifically, it says that: E(Ri) = Rf +
[E(RM) - Rf] X bi .
In short, the expected return for a given asset is a function of three
things:
1. The
pure time value of money,
2. The
reward for bearing systematic risk,
3. The
amount of systematic risk.
The
SML and the Cost of Capital: A Preview
The
Basic Idea The SML tells us the "market price of risk" in
the financial markets at a point in time. Shareholders benefit only if
managers are able to find investments with expected returns that exceed
the return available in the financial markets for a given level of risk.
Such an investment will have a positive NPV, because its return exceeds
its cost.
The
Cost of Capital is the minimum required return on an investment, based
on its risk. This return can now be measured using the SML.
(54.0K)