T8: Risk and Return in Capital Markets

Realized Return

The actual return earned on an investment over a period; equals price change plus dividends divided by the starting price

Systematic Risk

Risk that affects the entire economy and cannot be diversified away; examples include interest rates, inflation, and recessions; the only risk that earns a return premium

Unsystematic Risk

Firm-specific risk that affects only a small number of assets and can be eliminated through diversification; earns no return premium

Diversification

The process of combining assets in a portfolio to reduce unsystematic risk; does not eliminate systematic risk

Variance

A measure of how spread out an asset's returns are around the average; computed using T-1 in the denominator from historical data

Volatility

The standard deviation of returns; same units as return (%) making it easier to interpret than variance

Covariance

Measures how two assets' returns move together; positive means same direction, negative means opposite directions; computed using T-1

Correlation

Covariance scaled by the product of the two standard deviations; always between -1 and +1; easier to interpret than covariance

Risk Premium

The expected return above the risk-free rate; determined solely by an asset's systematic risk, not its total volatility