Risk-averse investors will demand higher risk premiums to place their wealth in portfolios with HIGHER VOLATILITY Risk

Premium will be greater the greater the risk aversion Sharp is only valid for ranking portfolios and not valid for individual assets Capital Allocation Line -expected return vs. standard deviation -line plots risk-return combinations by varying asset allocation (how much in risk-free and risky) -slope = sharpe = expected return per unit of standard deviation -what about points to the right of P? (Y>1) -means they are borrowing -slope stays the same if they borrow at the same risk-free rate We call the capital market line Macroeconomic factors = business cycle, inflation rate, interest rates, exchange rates Firm specific = research and development, management style Since firm-specific is independent, the portfolio could reduce when adding them together Law of averages -The portfolio standard deviation is a weighted average of the component security standard deviations only in the special case of perfect positive correlation (1) -Will give us a straight line -Perfect positive correlation is the only case in which no benefit from diversification -When it is less than 1, the standard deviation will be less than the weighted average of standard deviations -so there is benefit from diversification as long as the correlation is not 1 When the correlation is negative, there will even be a greater benefit from diversification P = -1 Can push all risk all the way down to zero When we add the risk-free asset to a stock/bond risky portfolio, the resulting opportunity set is the straight line we call CAL (capital allocation line) Now we will consider various CAL's with risk-free bills and different risky portfolios We can do better than the minimum variance portfolio (get a steeper CAL) -steeper cal means you are getting a higher return for any level of volatlity All investors will choose O as their risky portfolio because it results in the highest return to per unit risk (steepest CAL) Investors will only differ in their allocation of investment funds between portfolio O and risk-free asset (depending on their risk aversion) Risk-Return Opportunity = most northwestern portfolios in terms of expected return and standard deviation from the universe of securities Efficient Frontier = represents the set of portfolios that offer the highest possible expected return for each level of standard deviation

-any INDIVIDUAL ASSETS end up inside the curve because they are inefficient because they are not diversified When choosing portfolios, we can immediately discard portfolios below the minimum-variance portfolio -these are dominated with the upper half of the frontier because they have higher return and equal risk So the real choice is among portfolios on the efficient frontier and above the minimum variance portfolio This call dominates all feasible CAL because it has the steepest slope (reward to risk) A portfolio manager will offer the same risky portfolio no matter what the degree of risk aversion is Risk aversion only comes into play when selecting their desired point on CAL Single Index Model Assuming that one common factor is RESPONSIBLE FOR ALL THE COVARIABILITY OF STOCK RETURNS, with all the variability due to firm-specific factors, dramatically simplifies the analysis Beta = stock's comparative sensitivity to macroeconomic news -a value greater than 1 would indicate a stock with greater sensitivity to the economy than the average stock in the market -known as cyclical stocks -beta less than 1 would be mean below-average sensitivity and therefore known as defensive stock -measure systemic risk (uncertainty that pervades the whole economic system) e = firm-specific risk or residual risk -expected value of E is zero alpha = return on the stock BEYOND any return induced by movement in the market index -positive alpha is attractive because it suggests an underpriced security Firm-specific risk = part of uncertainty INDEPENDENT OF THE OVERALL MARKET -because firm-specific component of a firm's return is uncorrelated with the market return we can write it like this Security Characteristic Line The greater the beta, the greater the slope of the regression, the greater the security's systemic risk, as well as total variance The average security has a beta of 1.0 because the market is composed of all securities and the typical response to the market movement must be 1 to 1 greater than 1 = aggressive less than 1 = defensive negative beta -more favorable macro events will expect lower returns -however when the economy goes bad than positive beta will have negative excess returns while negative beta's will shine Negative beta gives us negative systemic risk and that is provide a hedge against systemic risk The dispersion of the scatter around the regression line is determined by the residual variance (which measures firm's specific risk)

The magnitude of firm-specific risk varies across securities. One way to measure the relative importance of systemic risk is to measure the ratio of systematic variance to total variance. R^2 -measures the ratio of explained variance to total variance (the portion of total variance that can be explained by market fluctuations When correlation at extremes, 1.0 or -1.0 then security returns can fully be explained by market return (R^2 will be 1) -all points of the scatter diagram will be on the exact same line A large correlation coefficient means systemic variance dominates the total variance (that is firm-specific variance is relatively not important) (look at R^2 equation) When the correlation coefficient is small, the market plays a relatively unimportant role in explaining the variance of the asset and firm specific dominates (look at R^2 equation) The beta of a portfolio is SIMPLY THE AVERAGE OF THE INDIVIDUAL SECURITY BETAS -the systematic part of the risk is still only determined by the market factor and therefore no diversification effects on the systemic risk no matter how many securities are involved As far as the "market risk goes" , portfolios with small betas will have a small systematic risk for the portfolio (don't forget the firm specific though) Because firm specific effects are independent of each other, their risk effects are offsetting, their risk are offsetting We can control the systematic risk by manipulating the average betas but the number of securities have no consequence But for NONSYSTEMATIC RISK the number of securities involved is more important than firm-specific variance of the securities -sufficient diversification can virtually eliminate firm-specific risk Simplification of index model is NOT COSTLESS The cost is that it places RESTRICITON on the structure of the asset return UNCERTAINTY. The classification of uncertainty into a simple dichotomy (macro and micro factor) oversimplifies the source of real-world uncertainty -misses important ones like industry events (events that affect the many firms in the industry without substantially affecting the broad macro economy) Because e's are independent and all have zero expected value, the law of averages can be applied to conclude that as more and more stocks are added to the portfolio, the firm specific components tend to cancel out, resulting in a smaller non-market risk component (this is why we call it diversifiable risk)