Lecture12 - LECTURE 12 RISK AND RETURN PART 3: SYSTEMATIC...

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137 L ECTURE 12 R ISK AND R ETURN P ART 3: S YSTEMATIC R ISK , P ORTFOLIO C HOICE , AND THE C APITAL A SSET P RICING M ODEL Reading: Chapter 11 plus appendix on the course website Homework: Online problems plus supplemental CAPM problems Objectives: Understand the Difference Between Systematic and Unsystematic Risk Understand the Portfolio Choice Problem Understand the Capital Asset Pricing Model and how Systematic Risk is Measured and Priced Be able to use the CAPM to estimate expected returns on stocks
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138 List of Important Concepts in this Section Systematic risk, also called undiversifiable risk or market risk Unsystematic risk, also called diversifiable risk, unique risk, asset- specific risk, or idiosyncratic risk The Efficient Frontier The Capital Market Line The Market Portfolio The Capital Asset Pricing Model (or CAPM) Professor Bill Sharpe Beta The Characteristic Line The Security Market Line
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139 Symbol Key: R p Return on some portfolio R m Return on the market portfolio R i Return on asset i E[R p ] or E[R m ] Expected return of m or p r f Return on the risk-free asset σ i Standard deviation of asset i σ m Standard deviation of the market σ p Standard deviation of a portfolio p ρ i,j Correlation between i and j, which can be assets or portfolios α Proportion of your wealth you invest in some portfolio, usually the market portfolio; check the context
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140 Diversification and Risk ± Because diversification reduces risk, rational investors will hold portfolios of a large number assets ± We’ve already seen that as the number of assets gets large, an individual asset’s variance has a negligible effect on portfolio risk ± Rather, it’s the asset’s covariance with the other assets and determines how much it increases portfolio risk ¾ Investors, therefore, don’t care about the portion of a asset’s risk that is not correlated with the other assets ¾ Investors DO care about that portion of an asset’s risk that is correlated with the other assets ² That’s because it results in higher covariance ² Recall the relation between correlation and covariance: cov( , ) ( , ) stock portfolio Stock Portfolio stock portfolio σ σρ = Where σ is a standard deviation, and ρ is the correlation.
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141 Diversifiable vs. Non-diversifiable Risk ± The portion of the asset’s risk not correlated with other assets that investors hold is called diversifiable risk ¾ We give it this name because this risk shrinks as you diversify ¾ Because it shrinks, it has no effect on price and investors are not compensated with a higher return for taking on diversifiable risk ¾ Other names for diversifiable risk inclue unsystematic risk, unique risk, idiosynchratic risk, and asset-specific risk ± The portion of an asset’s risk that is correlated with other assets that intestors hold is called Non-diversifiable or systematic risk ¾ This portion of the asset’s risk does not shrink as you diversify; it stays because it is correlated with other assets ¾
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.

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Lecture12 - LECTURE 12 RISK AND RETURN PART 3: SYSTEMATIC...

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