32 terms

Portfolio Weight

The relative investment in your portfolio

Portfolio Return

The total return earned on your portfolio, accounting for the returns of all of the securities in the portfolio and their weights

Portfolio Expected Return

The return you can expect to earn on your portfolio, given the expected returns of the securities in that portfolio and the relative amount that you have invested in each

Diversification

Combining different stocks in a portfolio. This eliminates SOME risk. The remaining risk depends upon the degree to which the stocks share common risk

Volatility of a Portfolio

The total risk of the portfolio (measured as a standard deviation)

What happens if you combine airline stocks?

Volatility is reduced only slightly compared to the individual stocks.

What happens if you combine airline and oil stocks?

Volatility is reduced below that of either stock.

Correlation

- Measuring stocks' co-movement

- The degree to which the stocks share common risk

- Ranges from -1 to +1

- The degree to which the stocks share common risk

- Ranges from -1 to +1

To find the risk of the portfolio, we need to know:

1. The risk of the component stocks

2. The degree to which they move together

2. The degree to which they move together

We want assets with a ________ correlation, and thus _______ risk.

Lower, Lower

A correlation of ______ is ideal, yet hard to come by.

-1

Market Portfolio

The sum of everything we own.

Market Portfolio concepts:

- The sum of all investors portfolios must equal the portfolio of of all risky securities in the market.

- The market portfolio is the portfolio of all risky investments, held in proportion to their value.

- Thus, the market portfolio contains more of the largest companies and less of the smallest companies.

- The market portfolio is the portfolio of all risky investments, held in proportion to their value.

- Thus, the market portfolio contains more of the largest companies and less of the smallest companies.

Market Proxy

A portfolio whose return should track the underlying, unobservable market portfolio

Market Index

-The most common market proxy portfolio

-Reports the value of a particular portfolio

- Ex: DOW Jones Industrial Average, S&P 500

-Reports the value of a particular portfolio

- Ex: DOW Jones Industrial Average, S&P 500

S&P 500

- Only represents a small fraction (approx. 10 %) of the number of public firms.

- Represents a large fraction (approx. 65%) of total market capitalization of public firms.

- Represents a large fraction (approx. 65%) of total market capitalization of public firms.

Beta

Symbol for the measure of risk

Market Risk and Beta

- We compare a stock's historical returns to the market's historical returns to determine a stock's beta (B)

- The sensitivity of an investment to fluctuations in the market portfolio

- Use excess returns= security returns - the risk free rate

- The percentage change in the stock's return that we expect for each 1% change in the market's return

- The sensitivity of an investment to fluctuations in the market portfolio

- Use excess returns= security returns - the risk free rate

- The percentage change in the stock's return that we expect for each 1% change in the market's return

Data estimates of Beta

- Most use 2 to 5 years of weekly or monthly returns

- Most use the S&P 500 as the market portfolio

- Most use the S&P 500 as the market portfolio

The beta of the overall market portfolio is _____ .

1

Differences in Beta

- Many industries and companies have betas higher/ lower than 1

- Differences in betas by industry are related to the sensitivity of each industry's profits to the general health of the economy

- Differences in betas by industry are related to the sensitivity of each industry's profits to the general health of the economy

Higher standard deviation = ________ total risk

More

(Total risk is measured with standard deviation)

(Total risk is measured with standard deviation)

Higher Beta = _________ systematic risk

More

(Systematic risk is measured with Beta)

(Systematic risk is measured with Beta)

Cost of Equity Capital

-The best available expected return offered in the market on a similar investment.

-To compute the cost of equity capital, we need to know the relation between the stock's risk and its expected return.

-To compute the cost of equity capital, we need to know the relation between the stock's risk and its expected return.

The CAPM Equation Relating Risk to Expected Return

- Only systematic risk determines expected returns

- Firm-specific risk is diversifiable and does not warrant extra return.

- Firm-specific risk is diversifiable and does not warrant extra return.

The expected return on any investment comes from:

- A risk-free rate of return to compensate for inflation and the time value of money, even with no risk of losing money.

- A risk premium that varies with the systematic risk

- A risk premium that varies with the systematic risk

Expected Return

= Risk-free rate + Risk Premium for Systematic Risk

"Risk Premium for Systematic Risk"

-The CAPM says that the expected return on any investment is equal to the risk-free rate of return plus a risk premium proportional to the amount of systematic risk in the investment.

-The risk premium is equal to the market risk premium times the amount of systematic risk present in the investment, measured by its beta (βi).

-We also call this return the investment's required return.

-The risk premium is equal to the market risk premium times the amount of systematic risk present in the investment, measured by its beta (βi).

-We also call this return the investment's required return.

The Security Market Line

- The CAPM implies a linear relation between a stock's beta and its expected return.

- This line is graphed in Figure 12.9(b) as the line through the risk-free investment (with a beta of zero) and the market (with a beta of one); it is called the security market line (SML).

- There is no clear relation between a stock's standard deviation (volatility) and its expected return

- The relation between risk and return for individual securities is only evident when we measure market risk rather than total risk.

- Y-axis: EXPECTED RETURN

-X- axis: BETA

- This line is graphed in Figure 12.9(b) as the line through the risk-free investment (with a beta of zero) and the market (with a beta of one); it is called the security market line (SML).

- There is no clear relation between a stock's standard deviation (volatility) and its expected return

- The relation between risk and return for individual securities is only evident when we measure market risk rather than total risk.

- Y-axis: EXPECTED RETURN

-X- axis: BETA

The CAPM and Portfolios

- We can apply the SML to portfolios as well as individual securities.

- The market portfolio is on the SML, and according to the CAPM, other portfolios (such as mutual funds) are also on the SML.

- The expected return of a portfolio should correspond to the portfolio's beta.

- The market portfolio is on the SML, and according to the CAPM, other portfolios (such as mutual funds) are also on the SML.

- The expected return of a portfolio should correspond to the portfolio's beta.

Summary of the Capital Asset Pricing Model

- Investors require a risk premium proportional to the amount of systematic risk they are bearing.

- We can measure systematic risk using beta (β)

- The most common way to estimate beta is to use linear regression - the slope of the line is the stock's beta

- We can measure systematic risk using beta (β)

- The most common way to estimate beta is to use linear regression - the slope of the line is the stock's beta

The more Beta risk we have, the more _______ risk we have.

systematic