Ch 8

Cards (48)

  • 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