Chapter 13: Return, Risk, and the Security Market Line

Question 1

States of the economy

Answer 1

For example, suppose the economy booms. In this case, we think Stock L would have a 70% return. If the economy enters a recession, we think the return would be −20%.

Thus we have two states of the economy

Meaning there are only 2 possible situations

Question 2

Expected return

Answer 2

Return on a risky asset expected in the future.

Question 3

To find the expected return:

Answer 3

Take the :Probability of State of the Economy” number (say 0.5), and the “Security Returns if State Occurs” ( say -20% and 70%) and multiply each number to the 0.5.

E(Ru) = (0.50 x -20%) + (0.50 x 70%) = 25%

Question 4

portfolio

Answer 4

Group of assets such as stocks and bonds held by an investor.

AKA investors hold more than one kind of stock

Question 5

portfolio weights

Answer 5

Percentage of a portfolio’s total value in a particular asset.

Must always = 100% or 1

Question 6

TABLE 13.6

Variance on an equally weighted portfolio of Stock L and Stock U STEPS

Answer 6

(1) State of Economy (shows the boom and the bust)
(2) Probability of State of Economy (Included in the question)
(3) Portfolio Return if State Occurs (Included in the question)
(4) Squared Deviation from Expected Return (Take info from step 3 and subtract expected return. Take this number and square it
(5) Product step (2) × step (4)

Question 7

Correlation

Answer 7

which provides a measure on the extent to which the returns on two assets move together

• If correlation is positive, we say that Assets A and B are positively correlated
• If correlation = 0 than the are uncorrelated

If correlation = 1 or -1, it is perfectly positively correlated or perfectly negatively correlated

Question 8

The return on any stock traded in a financial market is composed of two parts.

Answer 8

First, the normal or expected return from the stock is the part of the return that shareholders in the market predict or expect

The second part of the return on the stock is the uncertain or risky part

Question 9

One way to write the return of a stock in the coming year

Answer 9

Total return = Expected return + Unexpected return

R = E(R) + U

Question 10

innovation or the surprise

Answer 10

Lets say we predicted GNP to raise 0.5% but it actually raised 1.5%, this would be a surprise to us

Question 11

Announcement =

Answer 11

Expected part + Surprise

The expected part of any announcement is the part of the information that the market uses to form the expectation, E(R), of the return on the stock

The surprise is the news that influences the unanticipated return on the stock

Question 12

After all, if we always receive exactly what we expect, the investment is perfectly predictable and, by definition, _______

Answer 12

risk free

Question 13

systematic risk

Also called market risk

Answer 13

A risk that influences a large number of assets
Made up of risk premium + Beta

Examples: GNP, interest rates, or inflation, are examples of systematic risks

Question 14

unsystematic risk

Also called unique or asset-specific risks.

Answer 14

A risk that affects, at most, a small number of assets.

Example: the announcement of an oil strike by a company, Unanticipated lawsuits, industrial accidents, strikes

Question 15

Announcement =

If a systematic and unsystematic risk exists

Answer 15

R = E(R) + Systematic portion + Unsystematic portion

This just breaks up ‘U’

Question 16

principle of diversification

Answer 16

Principle stating that spreading an investment across a number of assets eliminates some, but not all, of the risk.

Question 17

nondiversifiable risk

Answer 17

The minimum level of risk cannot be eliminated simply by diversifying

Question 18

Final remarks for unsystematic risk

Answer 18

Unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk

Question 19

Can systematic risk can be eliminated by diversification?

Answer 19

As a result, no matter how many assets we put into a portfolio, the systematic risk doesn’t go away. The terms systematic risk and nondiversifiable risk are used interchangeably.

Question 20

systematic risk principle

Answer 20

Principle stating that the expected return on a risky asset depends only on that asset’s systematic risk.

Question 21

beta coefficient

Answer 21

Amount of systematic risk present in a particular risky asset relative to an average risky asset.

Question 22

Do you want a high BETA or a low BETA

Answer 22

an investor who buys stock in Bank of Nova Scotia, with a beta of 1.33, should expect to earn less, on average, than an investor who buys stock in Teck Resources Limited, with a beta of 2.94.

High = more risk but potential greater reward

A BETA larger than has greater systematic risk than an average asset

Question 23

Portfolio Betas

Answer 23

When looking at the BETAs for two stocks you want to invest in to create a portfolio.

If you are looking to invest into 2 stocks equally, you can multiply their beta by 0.5 and add them together to get the combined portfolio beta

Question 24

characteristic line

Answer 24

To calculate beta, we draw a line relating the expected return on the security to different returns on the market

Question 25

Thus, a low R2 indicates that most of the risk of a firm is unsystematic

Answer 25

Know this

R squared

Question 26

security market line (SML)

Answer 26

Positively sloped straight line displaying the relationship between expected return and beta.

tells us the reward offered in financial markets for bearing risk

Question 27

market risk premium

Answer 27

Slope of the SML; the difference between the expected return on a market portfolio and the risk-free rate.

Question 28

capital asset pricing model (CAPM)

Answer 28

Equation of the SML showing the relationship between expected return and beta.

Question 29

The CAPM shows that the expected return for a particular asset depends on three things:

Answer 29

1) The pure time value of money. As measured by the risk-free rate, Rf, this is the reward for merely waiting for your money, without taking any risk.
2) The reward for bearing systematic risk. As measured by the market risk premium [E(RM) − Rf], this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting.
3) The amount of systematic risk. As measured by βi, this is the amount of systematic risk present in a particular asset, relative to an average asset.

Question 30

Arbitrage Pricing Theory (APT)

Answer 30

An equilibrium asset pricing theory that is derived from a factor model by using diversification and arbitrage. It shows that the expected return on any risky asset is a linear combination of various factors.

Question 31

In APT, Suppose there are three such factors: unanticipated changes in inflation, GNP, and interest rates. The total return can be expanded as:

Answer 31

R = E(R) + BiFi + Bgnp Fgnp + Br Fr + e

Question 32

What is a measure of total risk?

Answer 32

Standard deviation

Question 33

Total risk =

Answer 33

systematic risk + unsystematic risk

Question 34

The unexpected return on a risky assets depends only on that assets

Answer 34

systematic risk

Question 35

Total expected return =

Answer 35

Expected return + (beta x market risk premium) (This is CAPM)

Question 36

What does the Beta number tell us?

Answer 36

A beta of 1: Implies the asset has less systematic risk than the overall market

A beta of less than 1: Implies the asset has less systematic risk than the overall market

A beta of more than 1: Implies the asset has more systematic risk than the overall market

Question 37

What is a measure of systematic risk?

Answer 37

Beta

Question 38

The security with the higher expected return will be the one that

expected returns

bigger

larger

Answer 38

has the higher Beta