Sample_Chapter - Chapter 12 Return Risk and the Security...

Info icon This preview shows pages 1–3. Sign up to view the full content.

Return, Risk and the Security Market Line EVERY DAY, companies release news about their operations, and share prices respond as a result. In March 2010, WPP, ITV and Standard Chartered joined a host of other companies in announcing earnings. WPP announced a ‘brutal year’, with pre-tax profits down by 16.1 per cent. ITV stated that, while group revenues were down 7 per cent, it was able to make a pre-tax profit of £25 million. Finally, Standard Chartered announced a 13 per cent increase in pre-tax profits and a 7.2 per cent increase in dividends to shareholders. You would expect earnings increases to be good news and decreases to be bad news – they usually are. Even so, WPP’s share price increased by 4.2 per cent, ITV fell by 3.5 per cent, and Standard Chartered grew by 6.4 per cent. Although WPP’s news seemed negative, its share price went up. Similarly, ITV’s news seemed positive, but its share price fell. So when is good news really good news? The answer is fundamental to understanding risk and return, and the good news is this chapter explores it in some detail. ChapteR 12 paRt FouR: RiSk and RetuRn key notationS CapM Capital asset pricing model e( R ) Expected return R f Risk-free rate of return R p Portfolio return b Beta or systematic risk b p Portfolio beta s Standard deviation of returns s 2 Variance of returns LeaRninG oBJeCtiVeS After studying this chapter, you should understand: Lo1 How to calculate expected returns. Lo2 The impact of diversification. Lo3 The systematic risk principle. Lo4 The security market line and the risk-return trade-off. In our last chapter we learned some important lessons from capital market history. Most importantly, we learned that there is a reward, on average, for bearing risk. We called this reward a risk premium. The second lesson is that this risk premium is larger for riskier investments. This chapter explores the economic and managerial implications of this basic idea. Thus far we have concentrated mainly on the return behaviour of a few large port- folios. We need to expand our consideration to include individual assets. Specifically, we have two tasks to accomplish. First, we have to define risk, and discuss how to measure it. We then must quantify the relationship between an asset’s risk and its required return.
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

Expected Returns and Variances 345 When we examine the risks associated with individual assets, we find there are two types of risk: systematic and unsystematic. This distinction is crucial, because, as we shall see, systematic risk affects almost all assets in the economy, at least to some degree, whereas unsystematic risk affects at most a small number of assets. We then develop the principle of diversification, which shows that highly diversified portfolios will tend to have almost no unsystematic risk.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern