Ch 8

• risk: degree of uncertainty or potential loss
• 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
• excess return = return - risk free rate