two types of risk: systematic risk and unsystematic risk
systematic risk affects entire market and all firms
unsystematic risk affects individual stocks and is firm specific
systematic risk is non-diversifiable
unsystematic risk is diversable
capital asset pricing model (CAPM) defines the relationship between systematic (market) risk and return
CAPM equation: ri = rrf + (rm - rrf)bi
if we know an asset's systematic risk, we can use the CAPM to determine its expected return
the beta coefficient measures how much an investment moves relative to the market
if beta = 1, stock has the same risk as the market
if beta > 1, stock is riskier than the market
if beta < 1, stock is less risky than the market
beta of a risk free asset is 0
beta of the market is 1
ri = required return of portfolio/stock
rrf = risk free rate
rm = return on market
RPm = risk premium of market
bi = beta of portfolio/stock
RPm = rm - rrf
security market line (SML) shows the relationship between risk measured by beta and the required rates of return on individual securities
the SML's vertical axis is required rates of return
the SML's horizontal axis is risk measured by beta
if risk aversion increases, the slope of the SML gets steeper
if risk aversion decreases, the slope of the SML gets flatter
if inflation increases, the SML shifts up
if inflation decreases, the SML shifts down
y intercept of SML represents risk free rate where beta = 0
security plots above the SML are underpriced
security plots below the SML are overpriced
two types of investment risk: stand-alone risk and portfolio risk
investment risk is related to the probability of earning a low or negative actual return
T-Bills return the promised 3% regardless of the economy but they are exposed to inflation so they're not entirely risk free, as they have reinvestment risk
high tech returns move in a positive correlation with the economy
collections returns move in a negative correlation with the economy
standard deviation measures total or stand-alone risk
coefficient of variation = standard deviation / expected return
sharpe ratio is an alternative measure of stand-alone risk, that looks at excess return relative to risk