FINS1613 Lecture Notes - Lecture 8: Market Risk, Systematic Risk, Capital Asset Pricing Model

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29 May 2018

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Risk and Return, CAPM, Weighted

Average Cost of Capital

Risk and Return

General Rule – As risk increases, investors demand a higher rate of return.

Variance – The determination of spread between numbers in a data set against the average.

Standard Deviation – Square root of variance – put back into same units as data for

comparison sake.

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Normal Distribution

Expected Return and Variance

• Expected Return of a portfolio is the weighted average of the individual expected

returns.

(Averages out the return of the parts of your portfolio.)

= 

 

 

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• Variance (Standard Deviation^2) of two assets is given by

Systematic and Unsystematic Risk

Systematic Risk

Uncertainty which affects the entire market.

e.g Reserve Bank increases overnight cash rate, Earthquake

Unsystematic Risk

Uncertainty which is only specific to a certain company/share.

e.g CEO has a scandal, employees go on strike

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Document Summary

General rule as risk increases, investors demand a higher rate of return. Variance the determination of spread between numbers in a data set against the average. Standard deviation square root of variance put back into same units as data for comparison sake. Expected return and variance: expected return of a portfolio is the weighted average of the individual expected returns. (averages out the return of the parts of your portfolio. , variance (standard deviation^2) of two assets is given by. Uncertainty which affects the entire market. e. g reserve bank increases overnight cash rate, earthquake. Uncertainty which is only specific to a certain company/share. e. g ceo has a scandal, employees go on strike. Each company bears both systematic and unsystematic risk. Systematic risk is inherent as each share possesses the same - it adds up. Unsystematic risk disappears as you hold more shares, since they all get cancelled out.

Related Questions

Hi guys could someone help me and explain in detail the two fundamental principles of investments â the risk/return tradeoff and diversification. Also, describe how asset allocation and the correlation of various securities within asset classes impact the riskiness of an investorâs portfolio.

I found an answer but it seems to me very long and not sure about it so can you help me out guys

ANS:

Risk /Return Tradeoff

Risk, return and liquidity are three dimensions of investment decision. Risk/Return trade off considers two dimension ie risk and return. As risk of an investment increases , its expected return will decrease. Risk is measured by volatility of return which can be statistically obtained by standard deviation of return. Higher the standard deviation, higher will be volatility of return and higher the risk

Risk can be also measured as a relative risk compared to the market. This is measured by stock beta with reference to a market index. Higher the beta, higher the value of stock Beta, higher will be the risk .

Investors seeking higher return will need to take higher risks.

Treasury bonds are almost risk free assets. This has the lowest rate of return. Stocks have higher risk , hence have higher expected return. High beta stocks will have higher risk and higher returns.

An investor should understand his risk taking ability and will have to make a trade off between risk and return depending on his risk apetite.

Diversification:

There is a saying, do not put all your eggs in one basket. The reason is that it has higher risk if all eggs are in one basket. If the eggs are distributed in different basket, risk of loss decreases.

Same principle is applied in investment. Diversification reduces risk.

If one invests in different classes of assets like bonds, stock, commodities and properties âhis risk is likely to reduce. Reduction in return in one asset is likely to be compensated by return in other asset.

Within one class of asset also, there should be diversification to reduce risk.

For example one stock âA âmay have expected return of 10% and standard deviation of 5%.This risk can be reduced by diversification in number of assets and the ratio of Risk/return can be decreased.

If we diversify and instead of investing 100% in stock A, we invest 60% in âAâ and 40% in another stock âBâ having expected return15% and standard deviation of 8%.assume the correlation between the two assets are 0.5

Portfolio return=wa*Ra+wb*Rb

Wa=Weight of asset A=0.6

Wb=Weight of asset B=0.4

Ra=Return of A=10%

Rb=Return of B=15%

Sa=Standard deviation of A=5%

Sb=Standard deviation of B=8%

Corr(a,b)=Correlation of A & B=0.2

Portfolio return=0.6*10+0.4*15=12%

Portfolio Variance=(wa^2)*(Sa^2)+(wb^2)*(Sb^2)+2wa*wb*Cov(a,b)

Cov(a,b)=Corr(a,b)*Sa*Sb=0.1*5*8=4

Portfolio Variance=(0.6^2)*(5^2)+(0.4^2)*(8^2)+2*0.6*0.8*4=23.08

Portfolio standard deviation=Square root of Variance=(23.08^0.5)=4.8%

The diversification has increased return and reduced risk

Stock A was giving 10% return with 5% standard deviation. With diversification of portfolio we have 12% return and 4.8% standard deviation. Risk return ratio is decreased.

It may be noted that, higher the correlation between assets in the portfolio, higher will be risk in terms of standard deviation. Hence it is better to diversify with uncorrelated assets.

Diversification reduces unsystematic risk,but it cannot reduce systematic risk of overall market or economy

1. The diversification effect of a portfolio of two stocks: . A. increases as the correlation between the stocks declines. B. increases as the correlation between the stocks rises. C. decreases as the correlation between the stocks rises. D. Both A and C. E. None of the above. 2. Irene Adler is considering investing in the common stock of Holmes and Watson. The following data are available for the two securities. . ................... Expected Return ..... Standard Deviation Holmes .............. 0.12 ......................... 0.08 Watson ............. 0.19 .......................... 0.25 . If she invests 60% of her funds Holmes and 40% in Watson, and if the correlation of returns between these two securities is 0.45, what is the portfolioâs expected return and standard deviation? . A. 14.8% and 12.89% B. 13.6% and 11.03% C. 14.6% and 13.94% D. 14.4% and 11.03% E. 13.21% and 10.08% 3. What does a security bring to the risk of a well diversified portfolio? . A. It brings its standard deviation of possible returns. B. It brings its covariance with the other securities in the portfolio. C. It brings its total risk. D. It brings its unsystematic risk. 4. Diversification can effectively reduce risk. Once a portfolio is diversified, the type of risk remaining is: . A. individual security risk. B. riskless security risk. C. unsystematic risk D. systematic risk 5. Efficient portfolios are those, which offer: . A. Highest expected return for a given level of risk B. Highest risk for a given level of expected return C. The maximum risk and expected return D. All of the above

1. In the statement, "Based on the period 1950 â 1999, you would have the less uncertainty about any expected return on small company stocks than you would about the expected return on 3-month T-Bills.", changing "3-month T-Bills" to "large company stocks" would result in the statement being True.

2. In the statement, "Our author discusses the average return and standard deviation for 3 different assets for the period 1950 â 1999.", changing "3" to "4" would result in the statement being True.

3.In the statement," âDiversifiableâ risk, âCompany-specificâ risk, âSystematicâ risk and âMarketâ risk all refer to the same type of risk.", changing "Systematic" to "Unsystematic" would result in the statement being True.

4.In the statement, "By diversifying you can eliminate most or all of Systematic risk.", changing "Systematic" to "Unsystematic" would result in the statement being True. In the statement, "The variance is the square root of the standard deviation.", switching "variance" and "standard deviation" would result in the statement being True.

5.In the statement, "A stock with one-half the average market risk would have a value for beta of 2.0.", changing "2.0" to "0.5" would result in the statement being True.

6.In the statement, "The only variable on the right-hand side of the CAPM formula that varies from one company to another is the risk-free rate.", changing "risk-free rate" to "expected return on the market" would result in the statement being True.

7.In the statement, "In order to properly evaluate a stock, investors need only consider its risk premium.", changing "risk premium" to "risk" would result in the statement being True. In the statement, "Investors should always choose stocks with the lowest reward-risk ratio.", changing "lowest" to "highest" would result in the statement being True.

8.In the statement, "To find the standard deviation, we take the square root of the sum of the deviations of each observation from the mean of the observations.", changing "deviations" to "squared deviations" would make the statement True.

9. In the statement, "When working with the entire population of observations, the denominator of the variance calculation is (n -1).", changing "(n - 1)" to "n" would result in the statement being True. In the statement, "Ceteris paribus, higher standard deviations represent lower risk.", changing "higher" to "lower" would result in the statement being True.

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FINS1613 Lecture Notes - Lecture 8: Market Risk, Systematic Risk, Capital Asset Pricing Model

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