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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.

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chapter 2

CHAPTER 2

Risk and Return

topics in chapter 2
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
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
What is investment risk?
  • Risk exists any time returns are not known with certainty.
  • Why is risk important?
stand alone risk
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
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?
risk vs number of stock in portfolio
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 Portfolio
stand alone risk market risk diversifiable risk
Stand-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.
slide10
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
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
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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