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**preview**shows pages 1-2. to view the full**6 pages of the document.**CHAPTER 11: Systematic Risk and the Equity Risk Premium

The Expected Return of a Portfolio

• Portfolio Weight – the fraction of the total investment of each stock (WestJet, Hasbro,

Nike, etc.) in a portfolio.

• Return on a Portfolio – the weighted average of the returns on the investments in the

portfolio, where the weighs correspond to portfolio weights.

• Expected Return of a Portfolio – the weighted average of the expected returns of the

investments within it, using the portfolio weights.

The Volatility of a Portfolio

• Volatility of a Portfolio – the total risk, measured as SD, of a portfolio.

Diversifying Risks

• Investors care about return, but also risk.

• By combing stocks into a portfolio, we reduce risk through diversification.

• The amount of risk that is eliminated in a portfolio depends on the degree to which the

stocks face common risks and move together. For example, because the two airline

stocks tend to perform well or poorly at the same time, the portfolio of airline stocks

has a volatility that is only slightly lower than the volatility of the individual stocks. The

airline and oil stocks, on the other hand, do not move together – almost in opposite

directions. As a results, more risk is cancelled out, making that portfolio less risky.

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Measuig Stoks’ Co-Movement: Correlation

• Correlation – a measure of the degree (ranging from -1 to +1) to which returns share

common risk, calculated as the covariance of the returns divided by the SD of each

return.

• The closer the correlation is to +1, the more the returns tend to move together as a

result of common risk.

• When the correlation equals 0, the returns are uncorrelated – they have no tendency to

move together or in the opposite directions.

• The closer the correlation is to -1, the more the returns tend to move in opposite

directions.

• Stock returns will tend to move together if they are affected similarly by economic

events. So, stocks in the same industry tend to have highly correlated returns than

stocks in different industries.

• See page 381 to learn how to calculate correlation on Excel!

Copaig a Potfolio’s Vaiae ad SD

• The formula for the variance of a two-stok potfolio is…

• With a positive amount invested in each stock, the more the stocks move together and

the higher their correlation, the more volatile the portfolio will be. The portfolio will

have the greatest variance if the stocks have a perfect positive correlation (+1).

• The expected return of a portfolio is equal to the weighted average expected return of

its stocks, but the volatility of a portfolio is less than the weighted average volatility. As

a result, its clear that we can eliminated some volatility by diversifying.

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