FRL 301 Chapter 13 Blogs

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Terms in this set (...)

Systematic risk and example
Systematic risk, also known as market risk, is a risk that effects many different assets in the market, such as the announcement of a new minimum wage rates which influences the United States economy.
Unsystematic Risk and Example
unsystematic risks are risks that generally only influence a specific segment much like how an outbreak of e. coli in lettuce would impact the food industry.
Total Risk
Total risk is the sum of both systematic and unsystematic risks when making a financial decision
Principle of Investment Diversification
means that spreading an investment across a number of assets will eliminate some, but not all, of the risks. This principal tells us that Unsystematic Risk can be eliminated by diversification
Is investment diversification a good thing?
Diversification is always good. Without it, you expose yourself to unsystematic risk, and the marketplace doesn't reward you for that exposure.
How is total risk measured?
Total risk is measured by the standard deviation an investment's return, which is the sum of systematic risk and unsystematic risk.
How is systematic risk measured
Systematic risk is measured by the beta coefficient, which shows how much risk a particular asset has relative to an average risky asset.
what does the beta coefficient of a stock tell us about that stock?
The beta coefficient essentially tells us how big of a risk for a swing in prices a stock will have in comparison to the market's risk.

the coefficient is based on a percentage scale: Ex. 1.0 = 100% Market Risk. 0.5 = 50% of Market. 1.5 = 150% of Market.
How can a stock's beta be used to calculate the risk premium for that stock?
Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns You can also find the risk premium by multiplying the stock beta and the market risk premium (The difference between returns of the market and risk-free rate).
Why must all assets in the market have the same reward-to-risk ratio?
If you plot expected returns vs. beta (systematic risk), all stocks will plot on the same line if they are correctly priced.

If one stock offers a better reward to risk ratio than another, everyone would buy that stock, and no one would buy the stock with the lower reward to risk ratio. The prices of the two stocks would adjust, due to supply and demand, until an equilibrium is reached where the two stocks have the same reward to risk ratio. This example can be expanded to all assets in the marketplace.
If a stock at a given point in time has a reward-to-risk ratio larger than the slope of the Security Market Line (SML), is that stock over-valued, under-valued, or fairly priced?
The stock would be considered under-valued and the price of the stock price would rise until it met with the SML (security market line).
Explain why. What will happen to the price of that stock?
This happens because all stock needs to line up on the SML so if a stock is below the line then the price is over-valued and the stock price needs to lower and if the stock is above the line the stock price would rise.
According to the Capital Asset Pricing Model (CAPM), what determines the amount of reward an investor receives for bearing the risk associated with an individual security?
According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the market risk premium and the amount of systematic risk (that is referred as Beta) inherent in the security.
According to CAPM, reward for in investing in a risky security is based on the following:
1) The pure time value of money
2) The systematic risk of the security
3) The market risk premium
How are the Market Risk Premium (MRP) and the Security Market Line (SML) related?
The security market line is the line that results when we plot the expected returns and the beta coefficients, and the market risk premium is determined by the slope of the security market line.
security market line (SML)
A positively sloped straight line displaying the relationship between expected return and beta.
Higher the beta
higher the risk >1
lower the beta
lower the risk <1
positive beta
moving with the market
negative beta
moving away from the market