Risk Return & SML Flashcards
(22 cards)
- How do we calculate the expected return on a security?
It’s the weighted average of possible returns, based on their probabilities:
E[R] = p₁x₁ + p₂x₂ + … + pₙxₙ
This gives the long-term average return of the asset.
- In words, how do we calculate the variance of the expected return?
Find the deviation of each possible return from the expected return.
Square each deviation.
Multiply each squared deviation by its probability.
Sum those results to get the variance, and take the square root for standard deviation
- What is a portfolio weight?
It’s the percentage of a portfolio’s total value invested in a particular asset.
Example: If $50 is in Asset A and total portfolio is $200 → weight = 50/200 = 0.25
- In words, how do we calculate the expected return on a portfolio?
Multiply each asset’s expected return by its portfolio weight, then sum all the weighted returns.
- Is there a simple relationship between the standard deviation of a portfolio and the standard deviations of the assets in the portfolio?
No. The standard deviation of a portfolio depends on the correlations between assets. Diversification can lower portfolio risk, even if the individual assets are risky
- What are the two basic parts of a return?
Expected return (E) – based on known info
Unexpected return (U) – due to surprises (e.g., news or announcements)
So: Total Return = E + U
- Under what conditions will a company’s announcement have no effect on stock prices?
If the announcement is fully expected, it’s already priced in by the market. Only unexpected news moves stock prices
- What are the two basic types of risk?
Systematic risk (market risk) – affects many/all assets
Unsystematic risk (asset-specific risk) – affects only a single company or industry
- What is the distinction between the two types of risk?
Systematic risk: Non-diversifiable, comes from economy-wide events (e.g., inflation, interest rates)
Unsystematic risk: Diversifiable, comes from firm-specific events (e.g., management decisions, lawsuits)
- What happens to the standard deviation of returns in a portfolio if we increase the number of securities?
It decreases, especially by eliminating unsystematic risk. The more assets, the lower the overall volatility, up to a point
- What is the principle of diversification?
Spreading investments across multiple assets reduces risk by offsetting poor performance in some with gains in others.
- Why is some risk diversifiable? Why is some nondiversifiable?
Diversifiable risk is tied to individual assets and can be eliminated by diversification.
Nondiversifiable (systematic) risk affects the entire market and cannot be eliminated, no matter how diversified the portfolio is.
- Why can’t systematic risk be diversified away?
Because it affects all assets, like macroeconomic factors (interest rates, inflation, etc.)
- What is the systematic risk principle?
Only systematic risk matters in determining expected returns, since unsystematic risk can be diversified away. Investors are only rewarded for bearing market-wide risk
- What does a beta coefficient measure?
Beta (β) measures an asset’s sensitivity to market movements.
β = 1: same as market
β > 1: more volatile than market
β < 1: less volatile
- True or false: The expected return on a risky asset depends on that asset’s total risk.
False. It depends only on the systematic risk (measured by beta). Total risk includes unsystematic risk, which can be diversified away.
- How do you calculate a portfolio beta?
Use the weighted average of individual betas:
βₚ = w₁β₁ + w₂β₂ + … + wₙβₙ
- What is the fundamental relationship between risk and return in well-functioning markets?
Assets with higher systematic risk (β) should have higher expected returns to compensate investors.
- What is the security market line (SML)? Why must all assets plot directly on the SML in a well-functioning market?
SML shows the relationship between beta and expected return.
Assets must lie on the SML in equilibrium; otherwise, arbitrage will occur and push them back onto the line
- What is the capital asset pricing model (CAPM)? What does it tell us about the required return on a risky investment?
CAPM formula:
E[Rᵢ] = Rf + βᵢ (E[Rₘ] − Rf)
It tells us the required return on an investment based on:
The risk-free rate (Rf)
The market risk premium (E[Rₘ] − Rf)
The asset’s beta (βᵢ
- If an investment has a positive NPV, would it plot above or below the SML? Why?
It would plot above the SML, because it offers a higher return than required for its risk level—meaning it’s undervalued and creates value for shareholders.
- What is meant by the term cost of capital?
It’s the minimum required return necessary to justify an investment. It reflects the opportunity cost of using capital in one investment over another.
