FIN331 Exam 2 study guide

FIN331 Exam 2 study guide - Chapter 6 The return on a...

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Chapter 6 The return on a portfolio is a weighted average of the returns on the assets in the portfolio. If 2 or more assets with equal expected returns are combined, the expected return on the portfolio equals the expected return of the individual assets. Portfolio Risk In general, the risk (standard deviation) of a portfolio is lower than the risk of the individual assets. This reduction in risk is referred to as diversification. Diversification can reduce risk, but cannot eliminate it. On average, the standard deviation of returns of a single stock is about 35-40%.The standard deviation of returns of the S&P 500 is 20%. By investing in an S&P 500 index, the risk is about half as great as investing in a single stock. You still face the risk of a decline in the market: market risk. Components of Risk Market or systematic risk: risk related to macroeconomic conditions, or of a decline in the overall market. Nonsystematic or firm specific risk: risk that is unique to a particular industry or firm Total risk = Systematic + Nonsystematic Market risk Three terms that are used interchangeably are: Market risk, Systematic risk, Nondiversifiable risk These refer to the part of risk that cannot be eliminated by diversification Nonsystematic Risk Four terms used interchangeably:Nonsystematic risk; Firm-specific risk; Diversifiable risk;Unique risk These refer to the part of risk that can be eliminated by diversification Portfolio Risk To maximize the risk reduction benefits of diversification, combine securities whose returns have a low (or negative) correlation. Efficient Portfolio offers: The lowest risk for a given expected return Or , the highest expected return for a given risk level Extending Concepts to All Securities The optimal combinations result in lowest level of risk for a given return. The optimal trade-off is described as the efficient frontier , or investment opportunity set . Portfolios on the efficient frontier dominate all other
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This note was uploaded on 10/22/2010 for the course FIN 331 taught by Professor Pinto,k during the Fall '08 term at N. Arizona.

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FIN331 Exam 2 study guide - Chapter 6 The return on a...

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