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How do we choose b/t two investments if one has the higher expected return
but the other has the lower standard deviation? -> CV needed
*Coefficient of Variation: the standardized measure of the risk per unit of return;
calculated as the standard deviation divided by the expected return.
-The coefficient of variation shows the risk per unit of return, and it provides a more
meaningful risk measure when the expected returns on two alternatives are not the
same
Coefficient of variation = CV = sigma/ r hat
8-2e. risk aversion and required returns
Expected rate of return = (expected ending value-cost)/ cost
-most investors are risk-averse.
*Risk aversion: risk-averse investors dislike risk and require higher rates of returns
an inducement to buy riskier securities.
*Risk premium: the diference b/t the expected rate of return on a given risky assets
and that on -a less risky asset.
-in a market dominated by risk-averse investors, riskier securities compared to less
risky securities must have higher expected returns as estimated by the marginal
investor.
*Capital Asset Pricing Model: a model based on the proposition that any stocks
required rate of return is equal to the risk-free rate of return plus a risk premium
that reflects only the risk remaining after diversification.
- the risk o f a stock held in a portfolio is typically lower than the stocks risk when it
is held alone.
- the risk and return of an individual stock should be analyzed in terms of how the
security afects the risk and return of the portfolio in which it is held.
8-3a. expected portfolio returns, Rp hat
*expected return on a portfolio: the weighted average of the expected returns on
the assets held in the portfolio.
- expected return on a portfolio is a weighted average of expected returns on the
stocks in the portfolio.
-actual realized rates of return (Ri bar) would be diferent from the initial expected
values.
*Realized rate of return (r bar): the return that was actually earned during some
past period. The actual return usually turns out to be diferent fro
m the expected return except for riskless assets.
8-3b portfolio risk
-The portfolio risk, Siama P is not the weighted average of the individual stocks
standard deviations
-portfolios risk is generally smaller than the average of the stocks Siamas b/c
diversification lowers the portfolios risk.
*correlation: the tendency of two variables to move together
*correlation Coefficient (rho): measure of the degree of relationship b.t two
variables.
-perfectly negatively correlated = rho= -1.0
-perfect positive correlation = rho=1.0
-independent = rho = 0
-perfectly positively correlated stocks would be exactly risky as the individual stocks
b/c they would move up and down together
-correlation coefficient b/t the returns of two randomly selected stocks is about 0.3
(combining stocks into portfolio reduces risks but does not completely eliminate it)
-portfolio risk declines as the number of stocks in a portfolio increases.
*diversifiable risk: that part of a securitys risk associated with random events; it
can be eliminated by proper diversification. This risk is also known as company
specific, or unsystematic risk
*market risk: the risk that remains in a portfolio after diversification has eliminated
all company-specific risk. This risk is also known as non-diversifiable or systematic
or beta risk
1. portfolio risk declines as stocks are added, but at a decreasing rate. (add stocks
do little to reduce risk)
2.portfolios total risk can be divided into diversifiable risk and market risk.
(diversificable risk: risk eliminated by adding stocks / market risk: remains in every
stock
3. diversificable: random, unsystematic events. Because these events are random,
their efects on a portfolio can be eliminated by diversification
/ market risk: factors that systematically afect most firms , x eliminated by
diversification
4. if we choose stocks with low correlations + low stand-alone risk, the portfolios
risk would hold if we added stocks with high correlations and high Sigmas
5.people x hold market portfolio
*market portfolio: a portfolio consisting of all stocks
- b=1.0 -> diversifiable risk removed (2) still move up and down with the broad
market averages
- because a stocks beta reflects its contribution to the riskiness of a portfolio, beta
is the theoretically correct measure of the stocks riskiness
1. stocks risk has diversifiable risk and market risk
2. diversificable risk: can be emliminated by holding very large portfolios or buying
shares in a mutual fund
3.compensation is required only for risk that cannot be eliminated by diversification