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Chapter 2: Risk & Return

Topics Basic risk & return concepts Stand-alone risk Portfolio (market) risk Relationship between risk and return

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What are investment returns?

Returns measure the financial results of an investment.

Returns may be: ________________ ________________

Returns can be expressed in: ________________ ________________

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What is investment risk?

Typically, investment returns are not known with certainty.

Investment risk pertains to: Possibility of a ____________ Probability of earning __________ than

expected ________________________ associated

with returns

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Risk

Why is risk important?

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Stand-Alone Risk

Stand-alone (total) risk is the risk facing an investor who owns only _________ ______________.

_________________________measures the stand-alone risk of an investment.

Coefficient of variation (CV) and variance are also measures of stand-alone risk.

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Adding Stocks to a Portfolio

What happens to the risk and return of an average 1-stock portfolio as more randomly selected stocks were added?

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stock ≈ 35%Many stocks ≈ 20%

-75 -60 -45 -30 -15 0 15 30 45 60 75 90 105

Returns (% )

1 stock2 stocksMany stocks

810 20 30 40 2,000 stocks

Company Specific (Diversifiable) Risk

Market Risk

20%

0

Stand-Alone Risk, p

p

35%

Risk vs. Number of Stock in Portfolio

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Stand-alone risk = Market risk + Diversifiable risk

Market risk is that part of a security’s stand-alone risk that ______________ be eliminated by diversification.

Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that __________________ be eliminated by diversification.

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How is market risk measured for individual securities?

Market risk, is the contribution of a security to the overall riskiness of a well-diversified portfolio.

It is measured by a stock’s _________.

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Beta

In addition to measuring a stock’s contribution to the risk of a portfolio, beta also which measures the stock’s volatility relative to the ____________.

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How is beta interpreted?

If b = 1.0, stock has average risk. If b > 1.0, stock is riskier than

average. If b < 1.0, stock is less risky than

average. Most stocks have betas in the

range of 0.5 to 1.5.

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Use the SML to calculate an asset’s required return. The Security Market Line (SML) is part of

the Capital Asset Pricing Model (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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Use the SML to calculate anasset’s required return.

ri = rRF + (RPM)bi rRF = 7% rM = 15% RPM = rM – rRF = 15% – 7% = 8% bi = 1.25

ri = 7% + 1.25 (8%) = 17%

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Has the CAPM been completely confirmed or refuted?

No. There are difficulties in testing CAPM empirically: Investors’ required returns are based

on future risk, but betas are calculated with historical data.

Investors may be concerned about both stand-alone and market risk.