Chapter 10: Modeling Risk and Its Rewards

beta coefficient

a measure of an asset's sensitivity to systematic risk relative to the market as a whole. it measures the marginal impact an asset will have on the systematic risk of a portfolio. by definition, the riskless asset has a ____ of zero, while the market portfolio has a ____ of 1

capital asset pricing model (CAPM)

a model that expresses an asset's expected return as a linear combination of the risk-free rate, the asset's beta, and the market risk premium. the risk-free rate compensates investors for the inflation and waiting. the market risk premium is the average reward for bearing systematic risk in the economy. an asset's beta rescales the market risk premium to produce its risk premium

diversifiable risk

a risk that arises from an asset's uncorrelated price shocks, which an investor can cancel out by holding many assets that also have uncorrelated price changes. a risk an investor can easily avoid at almost no cost

other names for diversifiable risk

unsystematic, unique, asset-specific and idiosyncratic risk

diversification

the process of spreading investments across more than a single asset. ______ reduces a portfolio's unsystematic risk by investing in assets that don't move alike

Dow Jones Industrial Average (DJIA) / the Dow / the Industrials

a portfolio of market-leading companies tracked since the late 1880s. currently the index contains 30 companies across many industries, including financial services, healthcare, info tech, petroleum, pharmaceuticals, entertainment, insurance, food, home improvement, etc. it is price-weighted rather than value-weight portfolio

market portfolio

A theoretical portfolio that exhausts all opportunities for further diversification by holding a little bit of every risky asset in the economy. Nobody can hold the actual market portfolio because many risky assets are privately held and do not have tradable claims that all investors can hold. Well-diversified portfolios such as theS&P500 or NASDAQ Composite Index often serve as proxies for the market portfolio

NASDAQ Composite Index

a capitalization-weighted portfolio of the thousands of stocks listed on the NASDAQ stock exchange. a proxy for the market portfolio

nondiversifiable risk

a risk that arises from an asset's correlated price shocks, which an investor can't cancel out by holding many assets that also have correlated price changes. a risk that an investor can't easily and costlessly avoid this risk, and hence, must receive compensation to bear it

other names for nondiversifiable risk

market, systematic, and systemic

portfolio

a collection of assets held as an investment whose principal goal is to reduce risk

portfolio weight

the fraction of money invested in an asset that is part of a portfolio. portfolio weights sum to 1 to account for 100% of the invested money. assets held long have positive weights, while shorted assets have negative weights

reward-to-risk ratio

an asset's risk premium (economic good) divided by its beta (economic bad). in equilibrium, all asset's have the same reward-to-risk ratio due to traders' actions

S&P 500

a proxy for the market portfolio. a capitalization-weighted portfolio of the 500 largest U.S. publicly traded corporations

security market line (SML)

a positively sloped straight line that displays the relationship between an asset's expected return and its beta. the riskless rate is the intercept, and the market risk premium is its slope. the beta coefficient is the choice variable, and the asset's expected return in the dependent variable

standard deviation

the square root of the forward-looking variance. it measures total risk, how much an asset moves for all types of surprises

state-contingent return

an asset's realized return in a given state of the world. it is the expected return adjusted for correlated systematic errors and uncorrelated unsystematic errors

systematic risk / market risk

a surprise that produces correlated price changes across many assets. examples are interest rate changes, inflationary shocks, wars, changing in gdp, alterations to the tax code, financial crisis, etc. because assets respond to these surprises in a correlated fashion, an investor can't readily avoid these risk through a diversified portfolio. consequently one must receive a reward to bear systematic risk

systematic risk principle

Financial markets provide a reward for bearing risk, but not unnecessary risks.Unsystematic risk is an unnecessary risk because an investor can avoid it easily and at a low cost through diversification. The result is that the expected return on a risky asset depends only on that asset's systematic risk because that is the portion of the asset's total risk that is difficult for investors to avoid through diversification.

total return

The expected return plus the unexpected return. It is the realized state-contingent return once timeresolves the uncertainty. It differs from the expected return by the market and unique error terms

total risk

An asset's return volatility that results from all surprises, both systematic and unsystematic. The varianceand standard deviation measure total risk

unexpected return

A realized return's deviation from the expected return due to surprises. Unexpected returns canbe positive or negative and will converge on an average of zero as the number of draws increases over time.

asset-specific, unique, idiosyncratic risk, or unsystematic risks

A risk that affects one or, at most, a small numberof asset prices in an uncorrelated way. Essentially, white noise in a well-diversified portfolio. Since this is a risk thatan investor can avoid costlessly, an investor does not receive compensation for bearing it unnecessarily

variance

In this chapter, a forward-looking measure of an asset's anticipated return volatility. Unlike the equally-weighted scheme used in historical variance calculations, the forward-looking variance uses probabilities to weightthe squared deviations from the expected value