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### CHAPTER 2

Risk and Return

Topics in Chapter 2

- Basic return measurement
- Types of Risk addressed in Ch 2:
- Stand-alone (total) risk
- Portfolio (market) risk
- (Later, in Chapters 10 & 13, we consider within-firm risk)

- Relationship between risk and return: CAPM/SML

Investment Returns

- Returns may be: actual or expected.
- Returns can be expressed in: dollars or percentage.
- Returns include changes in asset value.

What is investment risk?

- Risk exists any time returns are not known with certainty.
- Why is risk important?

Stand-Alone Risk

- Stand-alone (total) risk is the risk facing an investor (firm) who owns only one asset.
- Measures of stand-alone risk:
- Standard deviation
- Variance
- Coefficient of variation (CV)

Adding Stocks to a Portfolio

- What happens to the average return of a one-stock portfolio as additional stocks are included?
- What happens to the risk of a one-stock portfolio as additional stocks are included?

s1 stock ≈ 35%sMany stocks ≈ 20%

p

Company Specific (Diversifiable) Risk

35%

Stand-Alone Risk, p

20%

0

Market Risk

10 20 30 40 2,000 stocks

Risk vs. Number of Stock in PortfolioStand-alone risk = Market risk + Diversifiable risk

- Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification.
- Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

Beta

- Market risk is measured by beta.
- Beta indicates:
- A stock’s contribution to the risk of a diversified portfolio
- The stock’s volatility relative to the market:
beta > 1.0 high risk

beta = 1.0 average risk

beta < 1.0 low risk

Using a Regression to Estimate Beta

- To estimate a stock’s beta, plot the stock’s returns on the Y axis and market returns on the X axis.
- The slope of the line of best fit as estimated through regression is the stock’s beta coefficient, or b.

Use the SML to calculate an asset’s required return.

- The Security Market Line (SML) is part of CAPM. The equation for the SML is:
- ri = rRF + (RPM)bi
- ri is the required return on security i
- rRF is the risk-free interest rate
- RPM is the risk premium on the market
- bi is the beta for security i

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