1. 2 - 1 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Chapter 2: Risk & Return Learning goals: 1. Meaning of risk 2. Why risk matters 3. Measures of return and stand-alone (or total) risk (Continued)

2. 2 - 2 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Chapter 2 Learning Goals, Cont. 4. Risk and return of a portfolio a.Diversifiable risk b.Market risk 5. Diversification and correlation 6. CAPM

3. 2 - 3 Copyright © 2002 by Harcourt College Publishers. All rights reserved. What is investment risk? Typically, investment returns are not known with certainty. Investment risk relates to: possibility of a ___________ the probability of earning ________ than expected ___________________________ associated with the returns.

4. 2 - 4 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Risk Risk is important because most investors (& managers) are __________________________. If investors are risk averse, they must be compensated for accepting risks.

5. 2 - 5 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Risk of a Single Asset Standard deviation is a statistical measure of _____________________. The larger the standard deviation, the greater _________________________ risk. Coefficient of variation and variance are alternative measures of stand- alone risk.

6. 2 - 6 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Risk of Portfolios A portfolio is a combination of assets. If investors are risk-averse, they will invest in portfolios rather than in single assets. Why? Because because part of the risk is eliminated by ___________________________. The assets owned by a firm form a portfolio.

7. 2 - 7 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Portfolio Risk To maximize the risk reduction effects of diversification, we combine assets whose returns have a low or negative ____________________________. In general, stocks have   0.65, so risk is lowered but not eliminated by combining stocks.

8. 2 - 8 Copyright © 2002 by Harcourt College Publishers. All rights reserved. # Stocks in Portfolio 102030 40 2,000+ Company Specific (Diversifiable) Risk Market Risk 20 0 Stand-Alone Risk,  p  p (%) 35

9. 2 - 9 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Stand-alone Risk & Market Risk The risk measures we have been considering so far (standard deviation and coefficient of variation) represent stand-alone risk. Stand-alone risk is important in many contexts, but according to CAPM, it is not the relevant risk for investors.

10. 2 - 10 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Stand-alone Risk & Market Risk According to CAPM, only __________________ risk is relevant to investors.

11. 2 - 11 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Stand-alone Market Diversifiable Market (or systematic) risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification. risk risk risk = +.

12. 2 - 12 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of a diversified portfolio. Market risk is measured by a stock’s _______________, which measures the stock’s volatility relative to the market. How is market risk measured for individual securities?

13. 2 - 13 Copyright © 2002 by Harcourt College Publishers. All rights reserved. If b = 1.0, stock has average risk. If b > 1.0, stock has above-average risk If b < 1.0, stock has below-average risk Most stocks have betas in the range of 0.5 to 1.5 How is beta interpreted?

14. 2 - 14 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Use the SML to calculate each alternative’s required return. The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). SML: r i = r RF + (RP M )b i. According to CAPM, the required return on an asset is determined by the SML equation. ^

15. 2 - 15 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Required rates of return SML: r i = r RF + (RP M )b i Assume r RF = 8%; r M = 15%. RP M = (r M - r RF ) = 15% - 8% = 7%. If stock i has a beta of 1.2: r i = 8 + 1.2 (7) = 16.4% The required return on stock i is 16.4%

16. 2 - 16 Copyright © 2002 by Harcourt College Publishers. All rights reserved. Portfolio Beta The beta of a portfolio is a weighted average of asset betas.