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1 Topic 5 Risk and return Objectives On completion of this topic, you should be able to: define and measure investment risk and return describe the nature of the risk-return trade-off explain and demonstrate how risk is reduced by diversification describe and identify the two components of an asset’s risk within a portfolio context: unsystematic and systematic risk describe, apply and appraise the Capital Asset Pricing Model (CAPM) use and interpret beta discuss the efficient markets hypothesis and its implications for investors Introduction In earlier topics, we have focussed on time value of money, a cornerstone concept in finance as demonstrated by its many applications. In this topic, we consider another powerful concept in finance, diversification, which then leads us to one of the enduring models of finance, the Capital Asset Pricing Model (CAPM). In the last topic, we introduced a fundamental valuation model that applies to all assets. Recall that, a general level, to value an asset we need to estimate the amount and timing of the asset’s cash flows, as well as a required rate of return that incorporates the asset’s risk to use as a discount rate. We then applied this model in the context of bond valuation. Share valuation is much more subjective than bond valuation. One of the reasons for this is the inability to directly observe the required return on a share, and therefore to derive a discount rate for our share valuation. The CAPM gives us an indirect method for estimating this required return via a theoretical model built on a number of assumptions. While not perfect, it has obvious practical implications for managers, investors and finance specialists who have little else to work off. From the company’s perspective, a shareholder’s required return is a cost. Therefore, the CAPM helps company management determine the cost of equity capital. In this topic, we will also build on some other ideas covered in our previous study. We extend the dimensions of risk, such as default risk, liquidity risk etc., as they apply to fixed income securities (e.g. bonds) to look at more general concepts of risk that apply to all investments. We start with total, or stand-alone, risk and then break this down into two important components systematic risk and unsystematic risk. We assume that investors are 'risk averse', that is, if two assets offer
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2 equal returns, the investor will select the asset with the lower level of risk. After careful study of this topic, you will have a solid understanding of the basics of risk and return that will allow you to analyse any investment more critically. What is return? In finance, a return is the gain or loss in wealth achieved on an investment over a given period of time. Recall from Week 1 that a focus of finance is measuring value over time and with uncertainty.
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