Risk and Return

Topics: Investment, Capital asset pricing model, Risk in finance Pages: 2 (321 words) Published: October 8, 2010
Risk and Return
Chapter 13

Portfolios
A

portfolio is a collection of assets  An asset’s risk and return is important as it affects the risk and return of the portfolio

Diversification
 Portfolio

diversification is the investment in several different asset classes or sectors  Diversification is not just holding a lot of assets  For example, if you own 50 internet stocks, you are not diversified t di ifi d  However, if you own 50 stocks that span 20 different industries, and 10 countries, then you are more diversified

Types of “Risk” Risk
 

Systematic Risk Unsystematic Risk

Systematic Risk
 Risk

factors that affects every business or every

asset  Also known as non-diversifiable risk or market risk I l d Includes such things as changes in GDP, h thi h i GDP inflation, interest rates, etc.

Unsystematic or Idiosyncratic Risk
 Risk

factors that affect a limited number of assets or a specific industry/company  Also known as unique risk and asset-specific risk I l d Includes such things as l b strikes, part h thi labor t ik t shortages, senior management departures, etc.

Diversifiable Risk
 The

risk that can be eliminated by combining assets into a portfolio  Often considered the same as unsystematic, unsystematic unique or asset-specific risk

Returns decomposition
 Total

Return = Risk free return + systematic portion + unsystematic portion

Measuring Systematic Risk
 How

do we measure systematic risk? y  We use the beta coefficient to measure y systematic risk  What does beta tell us? A beta of 1 implies the asset has the same systematic p y risk as the overall market  A beta < 1 implies the asset has less systematic risk than the overall market  A beta > 1 implies the asset has more systematic risk than the overall market 

example

Beta and the Risk Premium
 Remember

that the risk premium = expected return – risk-free rate  The higher the beta the greater the risk...
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