Chapter8. Risk and Rates of Return* What is “risk” and why does it matter?Finance/Investing dealing with the future -> uncertainty -> riskGiven uncertainty, the risk is that we may earn less than anticipated.Different investments have different levels of risk. Different people have different attitudes to risk. And the same person can have different risk attitudes depending on what is at stake. => Risk aversion is assumed. Risk Premium and required rate of return Risk increases => Higher required return => Lower Financial Value Sources or risk : macroeconomic, social, business, financial, etc* Probability distribution(p. 233, p. 234 Table 8-1, p. 235, Figure 8-2)Vs. Historical return dataExpected value vs. historical (=sample)average Variance and standard deviation (p.236) vs. sample stat Semi-varianceCoefficient of variationPortfolio risk and return – define and measureCML* Variance (or Standard Deviation) for Total risk about our total wealth (team’s performance) versus Another risk for an individual asset as a part of your wealth (individual player’s performance measured as his/her contribution to the team’s performance: how to pick a player foryour team-NFL draft?) => Concept of a portfolio=> See p.242, Figure 8-4 for a complete diversification effect, the total risk is completely eliminated? Very rare, but can still got the picture about diversification or the risk offsetting effectlike in Figure 8-5 on p.244Then, how do you measure the risk contribution of each security? – Market risk measured by beta! - Systematic (market, non-diversifiable) vs. unsystematic (idiosyncratic, beta, individual security) risk: see fig 8-6 on 246 Which one is relevant risk?Beta is to measure the systematic risk!CAPM, SML (P. 240, P. 251 – P. 258)Example on
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