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Lecture 6

MGT 181 Lecture Notes - Lecture 6: Expected Return, Systematic Risk, Market Risk


Department
Rady School of Management
Course Code
MGT 181
Professor
L Jean Dunn
Lecture
6

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November 3th, 2015
Expected returns are based on the probabilities of possible outcomes.
A portfolio is a collection of assets. An asset’s risk and return are important in how they affect
the risk and return of the portfolio. The risk-return trade-off for a portfolio is measured by the
portfolio expected return and standard deviation, just as with individual assets.
The expected return of a portfolio is the weighted average of the expected returns of the
respective assets in the portfolio.
Portfolio variance: Rp=w1R1+w2R2+...+wmRm
Expected vs Unexpected returns: Realized returns are generally not equal to expected returns.
At any point in time the unexpected return can be positive or negative. Over time, the average of
the unexpected component is zero.
Announcement and news contain both unexpected and expected components.
Efficient Markets: They are a result of investors trading on the unexpected portion of
announcements. The easier it is to trade on surprises, the more efficient markets should be.
Efficient markets involve random price changes because we cannot predict surprises.
Systematic risk: It involves risk factors that affect a large number of assets. It’s also known as
non-diversifiable risk or market risk. It includes changes in GDP, inflation, interest rates etc..
Unsystematic risk: It involves risk factors that affect a limited number of assets. It’s also known
as unique risk and asset-specific risk. It includes labor strikes, part shortages etc..
Returns: Total return = Expected return + unexpected return
Unexpected return = systematic portion and unsystematic portion
TOTAL return = Expected return + systematic portion + unsystematic portion
Diversifiable risk: the risk that can be eliminated by combining assets into a portfolio. Often
considered the same as unsystematic, unique or asset-specific risk.
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total risks. For well-diversified portfolios,
unsystematic risk is very small. The total risk for a diversified portfolio is essentially equivalent to
the systematic risk.
The systematic risk principle: There is a reward for bearing risk. There is no reward for bearing
risk unnecessarily. The expected return on a risky depends on its systematic risk.
If beta =1, the asset has a systematic risk identical to the market’s risk. If beta <1, the asset has
less systematic risk than the overall market. If beta >1, the asset has more systematic risk than
the overall market.
Risk premium = expected return - risk free rate
The higher the beta, the greater the risk premium should be.
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