Lecture 14 - Risk and Return CAPM I Flashcards
Correlation coefficients
Perfect positive = 1
Perfect negative = -1
Zero correlation = 0
Expected return on a portfolio
Expected return on a portfolio is simply a weighted average of the expected returns on individual securities
Variance
A measure of the uncertainty surrounding an outcome
A measure of risk
Covariance
A measure of how the returns on two assets co-vary or move together
Avoiding unsystematic risk
By increasing diversification in your portfolio, you can reduce and almost eliminate unsystematic risk.
However, you cannot avoid systematic risk
The separation principle
An investment decision is made up of two seperate steps:
- The investor will first estimate the optimal portfolio
- The investor must then decide how much to invest in the optimal portfolio and how much to invest/borrow in the risk free asset
Homogenous expectations
All investors have the same information and the same ability tp analyse it
Heterogeneous expectations
Investors have different information and different abilities to analyse the information
Three types of risk and measures
Total risk measured by variance
Systematic risk measured by covariance
Unsystematic risk measured by variance minus covariance
Beta coefficient
A measure of the systematic risk in an individual risky asset relative to that of the market portfolio
The beta coefficient measures the responsiveness of a security to movements in the market portfolio
What do beta values mean?
B<0 Asset moves in opposite direction to market
B=0 Movement of asset unrelated to market movement
B=1 Movement of asset generally in same direction as market
B>1 Movement of asset generally in same direction but more pronounced than market movement
Expected return on the market =
Rm = Rf + Risk Premium
CAPM formula
Er = Rf + B (Rm - Rf)
