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Chapter 12 Return, Risk, and the Security Market Line.docx

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FIN 501
Edward Blinder

FIN501 investment analysis I CHAPTER 12 RETURN, RISK, AND THE SECURITY MARKET LINE ANNOUNCEMENTS, SUPRISES, AND EXPECTED RETURNS  Risk that can be eliminated by diversification do not yield an expected reward; risk that cannot be eliminated by diversification does yield an expected reward  Security market line (SML) shows the relationship between risk and return ANNOUNCEMENT, SURPRISES, AND EXPECTED RETURNS  Return on any stock traded in a financial market is composed of two parts: 1. The expected return from the stock is the part of the return that investors predict or expect 2. The uncertain or risky part that comes from unexpected information revealed during the year  Total risk: an investment measured by the variance or standard deviation of its return  Total return: investment has expected return and unexpected return o On average, the actual return equals the expected return TOTAL RETURN - EXPECTED REUTRN = UNEXPECTED RETURN R - E(R) = U  An announcement can be broken into two parts: anticipated (expected) plus surprise (innovation) ANNOUNCEMENT = EXPECTED PART + SURPRISE EFFICIENT FRONTIER AND CAPITAL ASSET LINE  In the modern portfolio theory, investors would choose at every expected return level the assets and portfolio with minimum risk, assuming that investors are risk-averse and rational o Finding the minimum risk portfolio at every return level plots a parabola and the upper part of the parabola is called the efficient frontier  Capital asset line (CAL): When combining the risk-free asset with efficient frontier RISK: SYSTEMATIC AND UNSYSTEMATIC  Systematic risk (market risk): risk that influences a large number of assets o Uncertainties about general economic conditions, such as GDP, interest rate, or inflation  Unsystematic risk (unique or asset-specific risk): risk that influences a single company or a small group of companies  Total surprise component has a systematic and unsystematic component R - E(R) = SYSTEMATIC PORTION + UNSYSTEMATIC PORTION R - E(R) = U = m + ԑ DIVERSIFICATION, SYSTEMATIC RISK, AND UNSYSTEMATIC RISK  Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk  Systematic risk is not eliminated by diversification, so a portfolio with many assets will still have systematic risk SYSTEMATIC RISK AND BETA  Systematic risk principle: the reward for bearing risk depends only on the systematic risk of an investment o The expected return on an asset depends only on its systematic risk  Beta coefficient (β): measure of the relative systematic risk of an asset o Assets with betas larger (smaller) than 1 have more (less) systematic risk than average EX. Suppose you put half of your money in BCE and half in TELUS. What would the beta of this combination be? Bp= 0.5 x BCE+ 0.5 xTELUS THE SECURITY MARKET LINE EX. Consider Asset A with A(R )=20% anA β =1.6. Risk-free rfte is R=8%. Assume 25% of the portfolio is invested in Asset A. We can calculate expected return E(RP) = 0.25 x A(R ) + (1 – 0.f5) x R = 0.25 x 20% + 0.75 x 8% = 11% Beta on portfolioPβ βP= 0.25 x A + (1 – 0.25) x 0 = 0.25 x 1.6 = 0.4 FIN501 investment analysis I  It is possible for the percentage invested in Asset A to exceed 100% if the investor borrows at the risk-free rate and invests the proceeds in stocks EX. Suppose an investor has $100 and borrows an additional $50 at 8%, the risk-free rate. The total investment in Asset A would be $150, for 105% of the investor’s wealth E(R ) = 1.50 x E(R ) + (1 – 1.50) x R = 1.50 x 20% + 0.50 x 8% = 26% P A f βP= 1.50 x A + (1 – 1.50) x 0 = 1.50 x 1.6 = 2.4  The reward-to-risk ratio must be the same for all assets in a competitive financial market o Price and expected returns move in opposite direction - if Asset A’s price rise and expected return would decline; Asset B’s price would fall and expected return would rise (E(R ) – R ) / β = (E(R ) – R ) / β
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