BUSFIN 3220: CH. 13: Return, Risk, and Security Line Market

LEC

0

Expected Return:

The return on a risky asset expected in the future.

There are multiple methods to calculating expected

return: One method:

the expected return on a security is equal to

the sum of the possible returns multiplied by their

possibilities.

Calculating expected return: Other method

Capital Asset Pricing Model

Risk premium:

the difference between the return on

a risky investment and the return on a risk-free

investment

The projected (expected) risk premium is

the difference between the expected return on a risky

investment and the certain return on a risk-free

investment

Risk premium =

Expected return – Risk-free rate

Portfolio:

A group of assets such as stocks and

bonds held by an investor.

Portfolio Weight

• The percentage of a portfolio’s total value that is invested in a particular asset.

• The weights sum to 1.00, or 100%, because all money is

invested somewhere, even if the investment is cash

The expected return on a portfolio is

the weighted average of the expected returns of the assets in the

portfolio

Standard deviation

measures total risk, including

both systematic and unsystematic risk.

Diversification

helps reduce standard deviation by

eliminating unsystematic risk.

Systematic Risk:

A risk that influences a large number

of assets. Also called market risk.

Systematic Risk MORE

• cannot be eliminated by diversification

• Forces to which all firms are susceptible

• Examples: GDP, interest rates, inflation

Unsystematic Risk:

A risk that affects at most a small

number of assets. Also called unique or asset-specific

risk.

Unsystematic Risk MORE

• essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.

• Specific things to which a single firm or small number of firms are susceptible

• Examples: pharmaceutical research breakthrough, oil strike,

rocket technology advancement

The expected return (return on risky asset in future), and thus the risk premium (diff. between return on risky and risk free investment), of

an asset depends only on its

systematic risk (risk influences large number of assets.)

Because assets with larger betas have greater systematic

risks, they will have

greater expected returns.

Beta Coefficient:

The amount of systematic risk (risk influences large number of assets)

present in a particular risky asset relative to that in

an average asset.

An average asset has a beta of

1.0

The beta of the market is

1.0

Capital Asset Pricing Model (CAPM):

The equation of

the SML showing the relationship between expected

return and beta.

The CAPM shows that the expected return for a

particular asset depends on three things:

• 1.

The pure time value of money: As measured by the risk-free

rate, Rf, this is the reward for merely waiting for your money,

without taking any risk.

The CAPM shows that the expected return for a

particular asset depends on three things: 2

The reward for bearing systematic risk: As measured by the

market risk premium, E(RM) – Rf, this component is the reward

the market offers for bearing an average amount of systematic

risk in addition to waiting.

The CAPM shows that the expected return for a

particular asset depends on three things: 3

The amount of systematic risk: As measured by beta, ￿i, this

is the amount of systematic risk present in a particular asset or

portfolio, relative to that in an average asset.

The Security Market Line is the

graphical representation of the CAPM (equation of SML).

Security Market Line (SML):

A positively sloped

straight line displaying the relationship between

expected return and beta.

SML MORE

Describes the relationship between systematic risk and

expected return in financial markets

REC

0

Market Risk Premium:

The slope of the SML,

which is the difference between the expected return

on a market portfolio and the risk-free rate.