Chapter13 - Outline n n n n n n n n L13-1 Chapter 13....

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L13-1 Outline Chapter 13. Return, Risk, and the Security Market Line n Expected Returns and Variances n Portfolio Expected Returns and Variances n Portfolio Diversification n Risk: Systematic and Unsystematic n Systematic Risk and Beta n The Security Market Line n The Capital Asset Pricing Model n Summary and Conclusions
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L13-2 Lecture Outline n In this chapter, we will consider the relationship between risk and return for individual assets. To do so, we first define return and risk, and discuss how to measure them. Then, we will quantify the relationship between an asset’s risk and its required return. n When we examine the risks associated with individual assets, we find that there are two types of risk: systematic and unsystematic . Systematic risk affects almost all assets in the economy, whereas unsystematic risk affects at most a small number of assets. n We, then, develop the principle of diversification , which shows that highly diversified port- folios will tend to have almost no unsystematic risk. The principle of diversification has an important implication: to a diversified in- vestor, only systematic risk matters. In other words, in deciding whether or not to buy a particular individual asset, a diver- sified investor will only be concerned with that asset’s systematic risk.
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L13-3 Lecture Outline (cont’d) n This is the basis for a famous relationship between risk and return called the security mar- ket line , or SML . To develop the SML, we introduce the equally famous “ beta ” coefficient. Beta and the SML are key concepts in determining the required return on an invest- ment.
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L13-4 Expected Return and Vari- n The quantification of risk and return is a crucial aspect of modern finance. It is not possible to make “good” (i.e., value-maximizing) financial decisions unless one understands the relationship between risk and return. For past realized returns, we used arithmetic average returns and variances to represent return and risk, respectively. We now discuss how we can describe return and risk for future unrealized returns.
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L13-5 Expected Return and Vari- Example : Consider a single period of time, say, a year. We have two stocks, L and U, which have the following characteristics: Stock L is expected to have a return of 25%, and Stock U is expected to have a return of 20% in the coming year. If all investors agreed on the expected returns, why would anyone want to hold Stock U? In other words, Stock U should not exist. But, U exists. Why? The answer must depend on the risk of the two investments. The return on Stock L could actually turn out to be higher or lower than the expected return. So is for the Stock U. In other words, there may exist a situation in which Stock U may give higher re- turn than Stock L.
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L13-6 Expected Return and Vari- For example, suppose we have the following probability distribution: If you buy one of these stocks, say Stock U, what you earn in any particular year depends on what the economy does during that year. However, if the probabilities stay the same and you hold U for a number of
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This note was uploaded on 04/13/2010 for the course TECHNOLOGY 032913 taught by Professor Hong during the Spring '08 term at 서울대학교.

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Chapter13 - Outline n n n n n n n n L13-1 Chapter 13....

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