Chapter 13 - Return, Risk, and the Security Market Line

Expected Return

The weighted average of possible returns, based on probabilities of different outcomes.

Variance (in finance)

A measure of how returns differ from the expected return, accounting for probabilities of different outcomes.

Standard Deviation

The square root of variance; a common way to express total risk or volatility.

Portfolio

A collection of financial assets; risk and return depend on weights and correlations between assets.

Portfolio Expected Return

The weighted average of expected returns for each asset in the portfolio.

Portfolio Weights

The proportion of total investment in each asset within a portfolio.

Diversification

Combining multiple assets to reduce risk, especially unsystematic (asset-specific) risk.

Unsystematic Risk

Risk specific to a single company or industry; also called diversifiable or unique risk.

Systematic Risk

Market-wide risk that affects all investments; cannot be diversified away.

Total Risk

The combination of systematic and unsystematic risk; measured by standard deviation.

Principle of Diversification

Holding many different assets can reduce total risk without lowering expected returns.

Minimum Variance Portfolio

The combination of assets that produces the lowest possible risk.

Efficient Frontier

The set of optimal portfolios offering the highest return for a given level of risk.

Feasible Set

All possible combinations of portfolios that can be formed from a given set of assets.

Expected vs. Unexpected Return

Expected return is based on known info; unexpected return comes from surprises or new information.

Total Return = E(r) + U

Total return equals expected return plus the unexpected (surprise) component.

Systematic vs. Unsystematic Return

The surprise portion of return can be split into systematic (market-related) and unsystematic (asset-specific).

Beta (β)

A measure of an asset's sensitivity to systematic risk compared to the market (market beta = 1).

Interpretation of Beta

β > 1 = more volatile than market; β < 1 = less volatile than market; β = 1 = same as market.

Portfolio Beta

The weighted average of individual asset betas in a portfolio.

Systematic Risk Principle

Only systematic risk (not total risk) affects expected returns; only it is rewarded by the market.

Security Market Line (SML)

The graph of the CAPM; shows the relationship between beta and expected return.

Slope of the SML

The market risk premium (E(Rm) - Rf); represents the reward per unit of beta.

CAPM Formula

E(R) = Rf + β × (E(Rm) - Rf); used to calculate required return based on beta.

Reward-to-Risk Ratio

The slope of the line between a risk-free asset and a risky asset; calculated as (E(R) - Rf)/β.

Asset Above SML

Undervalued or underpriced; offers higher return than expected for its beta.

Asset Below SML

Overvalued or overpriced; offers lower return than expected for its beta.

Market Efficiency and Surprise

Only unexpected information moves prices in an efficient market; expected info is already priced in.