Unit 11 Return, Risk, and the Security

Expected Return

Average return based on the probabilities of possible outcomes, assuming the process repeats many times.

Probability

Chance of an outcome occurring. All probabilities add up to 100%.

Investment Risk

Probability of earning less than the expected return.

Stand-Alone Risk

Investment risk when an asset is considered by itself (in isolation).

Variance

Measures volatility using the weighted average of squared deviations from expected return.

Standard Deviation

Square root of variance; measures how much returns fluctuate.

Term

A collection of assets or investments.

Portfolio Expected Return

Weighted average of the expected returns of all assets in a portfolio.

Portfolio Weight

Amount invested in one asset divided by total portfolio investment.

Realized Return

The actual return earned, which may differ from expected return.

Unexpected Return

The surprise portion of a return; can be positive or negative.

Surprise Component of News

Unexpected information that affects stock prices and returns.

Systematic Risk

Risk affecting a large number of assets, such as GDP, inflation, or interest rate changes.

Unsystematic Risk

Risk affecting a limited number of assets, such as labor strikes or part shortages.

Market Risk

Another name for systematic risk; cannot be eliminated through diversification.

Asset-Specific Risk

Another name for unsystematic risk; affects only a few stocks.

Non-Diversifiable Risk

Systematic risk that cannot be eliminated.

Diversifiable Risk

Unsystematic risk that can be eliminated through diversification.

Total Risk

Systematic risk + unsystematic risk.

Total Return

Expected return + unexpected return.

Diversification

Investing in different asset classes or sectors to reduce risk.

Principle of Diversification

Combining assets reduces fluctuations in returns without an equivalent reduction in expected returns.

Diversifiable Risk

Risk eliminated by combining different assets into a portfolio.

Non-Diversifiable Risk

Risk that remains even after diversification.

Well-Diversified Portfolio

Portfolio with very little unsystematic risk remaining.

Systematic Risk Principle

Expected return depends only on systematic risk because unsystematic risk can be diversified away.

Beta (β)

Measures an asset's systematic risk relative to the overall market.

Beta = 1

Same systematic risk as the market (average-risk asset).

Beta less than 1

Less systematic risk than the market.

Beta greater than 1

More systematic risk than the market.

Portfolio Beta

Weighted average of the betas of all assets in a portfolio.

Risk Premium

Expected return minus the risk-free rate.

Beta and Risk Premium

Higher beta means a higher required risk premium.

Capital Asset Pricing Model (CAPM)

Formula defining the relationship between systematic risk and expected return.

Risk-Free Rate (Rf)

Return on a risk-free investment; the professor uses the T-bill rate.

Expected Market Return E(Rm)

Expected return on the overall market.

Market Risk Premium

Expected market return minus risk-free rate.

Security Market Line (SML)

Graph representing market equilibrium and the relationship between beta and expected return.

Slope of SML

Market risk premium, because market beta always equals 1.

Reward for Systematic Risk

Extra expected return investors require for bearing market risk.

Risk factors affecting many assets

Systematic risk

Risk factors affecting a limited number of assets

Unsystematic risk

Risk that cannot be eliminated

Systematic risk

Risk that can be eliminated

Unsystematic risk

Risk measured by standard deviation

Total risk

Risk measured by beta

Systematic risk

Weighted average of expected returns

Portfolio expected return

Expected return minus risk-free rate

Risk premium

Market return minus risk-free rate

Market risk premium

Relationship between risk and return

CAPM

Graph representing market equilibrium

Security Market Line

Slope of the Security Market Line

Market risk premium