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ADMS 3531 (17)
Chapter 12

Chapter 12 Detailed Note.docx

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Department
Administrative Studies
Course Code
ADMS 3531
Professor
Dale Domian

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Chapter 12 – Return, Risk, and the Security Market Line 12.1 – Announcements, Surprises, and Expected Returns Expected and Unexpected Returns  The return on any stock traded in a financial market is composed of two parts. o The normal, or expected, part of the return is the return that investors predict or expect. o The uncertain, or risky, part of the return comes from unexpected information revealed during the year.  R – actual total return in the year  E(R) – expected part of the return  U – unexpected part of the return o Because of surprises that occur during the year, R differs from the E(R) o The unexpected return will be positive or negative, but the average value of U will be zero o On average, the actual return equals the expected return Total Return = Expected Return + Unexpected Return Unexpected Return = Total Return - Expected Return U = R - E(R) Announcements and News  Firms make periodic announcements about events that may significantly impact the profits of the firm. o Earnings o Product development o Personnel  The impact of an announcement depends on how much of the announcement representsnew information. o When the situation is not as bad as previously thought, what seems to be bad news is actually good news. o When the situation is not as good as previously thought, what seems to be good news is actually bad news.  News about the future is what really matters. o Market participants factor predictions about the future into the expected part of the stock return. Announcement = Expected News + Surprise News 12.2 – Efficient Frontier and Capital Asset Line  Markowitz examined relationship between risk and return of asset prices and developed Efficient Frontier  This theory states that total risk level (standard deviation or variance) is the important factor in rewards of portfolios and portfolio preference of investors  He claims that investors fin the minimum risk portfolios at every return level and choose these portfolios over the others  When investors combine the risk-free asset with efficient frontier, they obtain a line called the CAL (Capital Asset Line) o The upper part of the parabola is called the efficient frontier o Markowitz states that every rational investor will chose his or her optimal portfolio on CAL according to his or her preferred risk level 12.3 – Risk: Systematic and Unsystematic Systematic and Unsystematic Risk  Systematic risk is risk that influences a large number of assets. Also called market risk.  Unsystematic risk is risk that influences a single company or a small group of companies. Also called unique risk or firm-specific risk. Total risk = Systematic risk + Unsystematic risk Systematic and Unsystematic Components of Return Recall: R – E(R)= U = Systematic portion + Unsystematic portion = m + e R – E(R)= m + e 12.4 – Diversification, Systematic Risk, and Unsystematic Risk Diversification and Unsystematic Risk  In a large portfolio:  Some stocks will go up in value because of positive company-specific events, while  Others will go down in value because of negative company-specific events.  Diversification essentially eliminates unsystematic risk, so a portfolio with many assets generally has almost no unsystematic risk.  Unsystematic risk is also called diversifiable risk.  Systematic risk is also called non-diversifiable risk. Diversification and Systematic Risk 12.5 – Systematic Risk and Beta The Systematic Risk Principle  What determines the size of the risk premium on a risky asset?  The systematic risk principle states: The expected return on an asset depends only on its systematic risk.  So, no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset. Measuring Systematic Risk  To be compensated for risk, the risk has to be special.  Unsystematic risk is not special.  Systematic risk is special.  The Beta coefficient (b) measures the relative systematic risk of an asset.  Assets with Betas larger than 1.0 have more systematic risk than average.  Assets with Betas smaller than 1.0 have less systematic risk than average.  Because assets with larger betas have greater systematic risks, they will have greater expected returns. Note that not all Betas are created equally. Portfolio Betas  The total risk of a portfolio has no simple relation to the total risk of the assets in the portfolio.  Recall the variance of a portfolio equation.  For two assets, you need two variances and the covariance.  For four assets, you need four variances and six covariances.  In contrast, a portfolio Beta can be calculated just like the expected return of a portfolio.  That is, you can multiply each asset’s Beta by its portfolio weight and then add the results to get the portfolio’s Beta. Example:  Using Value Line data from Table 12.1, we see  Beta for Starbucks (SBUX) is 1.15  Beta for Yahoo! (YHOO) 0.95  You put half your money into SBUX and half into YHOO.  What is your portfolio Beta? βp=.50×βSBUX+.50×βYHOO = .50×1.15+.50×0.95 = 1.05 12.6 – The Security Market Line Beta and the Risk Premium  Consider a portfolio made up of asset A and a risk-free asset. For asset AA E(R ) = A6% and b = 1.6. The risk-freefrate R = 4%. Note that for a risk-free asset, b = 0 by definition.  We can calculate some different possible portfolio expected returns and betas by changing the percentages invested in these two assets.  Note that if the investor borrows at the risk-free rate and invests the proceeds in asset A, the investment in asset A will exceed 100%. The Reward-to-Risk Ratio  Notice that all the combinations of portfolio expected returns and betas fall on a straight line.  Slope (Rise over Run): = E( )A −R f=16%−4% = 7.50% β 1.6 A • What this tells us is that asset A offers a reward-to-risk ratio of 7.50%. In other words, asset A has a risk premium of 7.50% per “unit” of systematic risk. The Basic Argument  Recall that for asseA A: E(R ) A 16% and b = 1.6  Suppose there is a second asset, asset B.  For asset B: B(R ) = 12%Aand b = 1.2  Which investment is better, asset A or asset B? Asset A has a higher expected return Asset B has a lower systematic risk measure  As before with Asset A, we can calculate some different possible portfolio expected returns and betas by changing the percentages invested in asset B and the risk-free rate. % of Portfolio in AsPortfolio Expected Portfolio Beta Return 0% 4 0.0 25 6 0.3 50 8 0.6 75 10 0.9 100 12 1.2 125 14 1.5 150 16 1.8 The Fundamental Result  The situation we have described for assets A and B cannot persist in a well-organized, active market Investors will be attracted to asset A (and buy A shares) Investors will shy away from asset B (and sell B shares)  This buying and selling will make The price of A shares increase The price of B shares decrease  This price adjustment continues until the two assets plot on exactly the same line.  That is, until: E R −R E R −R ( )A f= ( B f βA βB In general …  The reward-to-risk ratio must be the same for all assets in a competitive financial market.  If one asset has twice as much systematic risk as another asset, its risk premium will simply be twice as large.  Because the reward-to-risk ratio must be the same, all assets in the market must plot on the same line. The Security Market Line E R M)− Rf E R M)− Rf = = βM 1 = E(RM )− Rf  The Security market line (SML) is a graphical representation of the linear relationship between systematic risk and expected return in financial market
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