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CHAPTER 2

CHAPTER 2. Risk and Return. Topics in Chapter 2. Basic return measurement Types of Risk addressed in Ch 2: Stand-alone (total) risk Portfolio (market) risk (Later, in Chapters 10 & 13, we consider within-firm risk) Relationship between risk and return: CAPM/SML. Investment Returns.

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CHAPTER 2

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  1. CHAPTER 2 Risk and Return

  2. Topics in Chapter 2 • Basic return measurement • Types of Risk addressed in Ch 2: • Stand-alone (total) risk • Portfolio (market) risk • (Later, in Chapters 10 & 13, we consider within-firm risk) • Relationship between risk and return: CAPM/SML

  3. Investment Returns • Returns may be: actual or expected. • Returns can be expressed in: dollars or percentage. • Returns include changes in asset value.

  4. What is investment risk? • Risk exists any time returns are not known with certainty. • Why is risk important?

  5. Stand-Alone Risk • Stand-alone (total) risk is the risk facing an investor (firm) who owns only one asset. • Measures of stand-alone risk: • Standard deviation • Variance • Coefficient of variation (CV)

  6. Adding Stocks to a Portfolio • What happens to the average return of a one-stock portfolio as additional stocks are included? • What happens to the risk of a one-stock portfolio as additional stocks are included?

  7. s1 stock ≈ 35%sMany stocks ≈ 20%

  8. p Company Specific (Diversifiable) Risk 35% Stand-Alone Risk, p 20% 0 Market Risk 10 20 30 40 2,000 stocks Risk vs. Number of Stock in Portfolio

  9. Stand-alone risk = Market risk + Diversifiable risk • Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. • Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

  10. Beta • Market risk is measured by beta. • Beta indicates: • A stock’s contribution to the risk of a diversified portfolio • The stock’s volatility relative to the market: beta > 1.0 high risk beta = 1.0 average risk beta < 1.0 low risk

  11. Using a Regression to Estimate Beta • To estimate a stock’s beta, plot the stock’s returns on the Y axis and market returns on the X axis. • The slope of the line of best fit as estimated through regression is the stock’s beta coefficient, or b.

  12. Use the SML to calculate an asset’s required return. • The Security Market Line (SML) is part of CAPM. The equation for the SML is: • ri = rRF + (RPM)bi • ri is the required return on security i • rRF is the risk-free interest rate • RPM is the risk premium on the market • bi is the beta for security i

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