
Chapter 10

Probability distribution – assigns probability that each possible return will occur.
Expected return is the calculated weighted average of the possible returns. Variance is the
expected square deviation from the mean. Standard deviation = volatility = square root of
variance.

(1 + Rannual) = (1 + Rq1)(1 + Rq2)(1 + Rq3)(1 + Rq4)

Var(R) = 1/(T1) * Sum from t=1 to T ((Rt – R_ave)^2)

Standard Error = SD(Individual Risk)/(sqrt # observations)

Investments with higher volatility should have a higher risk premium and therefore
higher returns

Risks: Common risk is when a risk is perfectly correlated across everything (earthquakes
for many households), and independent risk is when the risks of one thing isn’t related to
the other thing (theft). So you want a
diversification
in order to average out the
independent risks in a large portfolio. Diversification is used to reduce risk.

There is firmspecific, idiosyncratic, unsystematic, unique, and diversifiable risk.

For diversified, good news will affect some stocks positively and others negatively

Systematic risk will affect all firms (and therefore the entire portfolio)

EX: S firms affected only by strength of economy and I firms have idiosyncratic,
firmspecified risks. There are 10 S firms and 10 I firms. If market will 50:50 be
40% or 20%. What is volatility and average return of each firm? Type S: .5*.4 + .
5*.2 = .1.
SD = 30%. For type I, it will 50:50 be 35% or 25%. Expected return is
5% and SD is also 30%. The average return of ten type S firms is also 10% and the
volatility is also 30%. The average return of ten type I firms is 5% and has volatility
.3/Sqrt(10) = 9.5%

The risk premium for diversifiable risk is 0 so investors are not compensated for
holding firmspecified risk. The risk premium depends on systematic risk and not
on diversifiable risk.

Systematic risk can only be eliminated by sacrificing expected returns

An efficient portfolio cannot be diversified further

The beta is the expected percent change in the excess return of a security for a 1%
change in the excess return of the market portfolio.
Unlike volatility, it measures the
riskiness relative specifically to the market.
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 Fall '10
 Kaminsky
 Capital Asset Pricing Model, Financial Markets, Modern portfolio theory

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