Ch.8 Risk and Rates of Return

Risk

The chance that some unfavorable even will occur.

An asset’s risk can be analyzed in two ways:

(1)on a stand-alone basis, where the asset is considered by itself and

(2)on a portfolio basis, where the asset is held as one of a number of assets in a portfolio.

Stand Alone Risk

The risk an investor would face if they held only one asset.

Probability Distributions

Listing of possible outcomes or events with a probability assigned to each outcome.

Expected Rate of Return

The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results.

Standard Deviation

A statistical measure of the variability of a set of observations. How far the actual return is likely to deviate from the expected return.

Coefficient of Variation

The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

Sharpe Ratio

A measure of standalone risk that comparers the asset’s realized excess return to its standard deviation over a specified period. An investment with a higher ratio has performed better than one with a lower ratio.

Risk Aversion

Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

Risk Premium (RP)

The difference between the expected rate of return on a given risky asset and that on a less risky asset.

Capital Asset Pricing Model (CAPM)

A model based on the proposition that nay stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.

Expected Return on a Portfolio

The weighted average of the expected returns on the assets held in the portfolio.

Realized Rates of Return

Returns that were actually earned during some past period. Actual returns usually turn out to be different from expected returns except for riskless assets.

Correlation

The tendency of two variables to move together.

Correlation Coefficient

A measure of the degree of relationship between two variables.

Diversifiable Risk

That part of a security’s risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company specific, or unsystematic risk.

Market Risk

The risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as non-diversifiable or systematic or beta risk.

Market Portfolio

A portfolio consisting of all stocks. Has low transaction costs and fees.

Relevant Risk

The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio’s market risk. It is measured by the extent to which the stock moves up or down with the market.

Beta Coefficient, b

A metric that shows the extent to which a given stock’s returns move up and down with the stock market. Beta measures market risk.

Average Stock’s Beta

By definition, bA=1 because an average-risk stock is one that tends to move up and down in step with the general market.

Market Risk Premium (RPM)

The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

required return on a stock

Security market line (SML) equation