Risk and Return part 3

• Firm-Specific Events 


  things that just affect that firm and maybe a few other
• Market-Wide Events 


  things that affect all firms, maybe not be equal, but everyone is affected
• Firm-Specific Events are

  Market-Wide Events are

  limited events

  worldwide events
• Does firm-specific or market-wide can get risk by diversification?

  firm-specific
• What risk are you stuck with?

  market-wide

  because it effects the whole market
• Unsystematic =


  firm-specific

  diversifiable
• Unsystematic 


  random events affecting only a firm or a few others

  eliminated by diversification
• Any extra return for taking unsystematic

  no
• Systematic =

  market

  undiversifiable
• Systematic


  cannot be eliminated by diversification
• Any extra return for taking systematic risk?

  Yes
• Diversified investor will 


  always win
• Undiversified investors will always 


  get outbid
• Systematic risk is 


  only compensated risk its the only risk that gets extra return
• What do you measure systematic risk with

  beta
• Beta


  is a stock's measure of market risk

  it's a regression coefficient

  how a stock return reacts(moves) to the market return
• market has beta = 1


  market moves the same as the market

  stock of beta of 1 tends to move as the market
• market has beta = 1 is called

  average risk stock
• market has beta = 1 


  has the same risk as the market and the same return as market
• beta is greater than 1

  stock moves more than the market

  more risk than the market and higher return than market
• 0 < B < 1

  stock moves less than the market
• B < 1

  less risk than the market and lower return than the market
• B = 2

  stock moves twice as much as the market

  Rm up 10% E(Rs) up 20%
• B = .5

  stock tends to move half as much as the market

  Rm up 10% E(Rs) up 5%
• Capital Asset Pricing Model (CAPM)

  gives required return for given beta

  it's the return you "should" expect or that is available for a given market risk

  with word " asset" , can determine the required return of any individual security with CAPM
• CAPM formula

  Ri = Rf + ( Rm - Rf)Bi

  Ri= required return for stock i

  Rf= risk-free rate - treasury security

  Rm= expected return on market

  Bi = beta of stock i

  (Rm-Rf) = market risk premium, extra return for investing in the market
• If risk-free rate is 5% and expected market return is 15%, compute the required return for stock when beta of 1

  15%
• If risk-free rate is 5% and expected market return is 15%, compute the required return for stock when beta of 2

  25%
• If risk-free rate is 5% and expected market return is 15%, compute the required return for stock when beta of 0.5

  10%
• If risk-free rate is 5% and expected market return is 15%, compute the required return for stock when beta of 0

  5%
• Portfolio Beta ( Bp)

  the beta for a portfolio IS the weighted average of the betas in a portfolio
• Bp=

  E wi * Bi

  weighted average * beta of stock
• Wi =

  value of stock i / value of portfolio
• Return on portfolio (Rp)

  Rp = Rf + ( Rm-Rf) Bp
• Stock, Value, Beta ( risk-free rate 3%, market risk premium 6%)

  a , 300, 0.8

  b , 600, 1.4

  c , 500, 1.2

  d, 600, 2.5

  Bp = 1.59

  Rp = 12.54%
• Securities Market Value

  Ri = Rf+(Rm-Rf)Bi and y= mx + b

  y = Ri

  m= (Rm-Rf)

  x= Bi

  b = Rf
• Intercept are

  interest rates

  interest rates go up, intercept goes up

  interest rate go dow , intercept foes down
• Slope =

  risk aversion

  more risk averse -> less willing to take risk

  if risk averse grows -> slope get stepper
• SML 


  the line tells you the required return for any level of market risk
• when beta is 0

  there is no market risk