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Class 11 - • Problem o Overconfidence of investors •...

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Ch. 8: Risk and Return Risk and return, capital market theory: o Realized return (at end of year): = = Expected return (at beg. of year) + “noise” o Riskier investments have historically higher SD What determines stock prices? o Good news about future cash flows o Efficient market hypothesis: Securities prices accurately reflect future expected cash flows Based on all information available to investors Thus, investors can’t predict future profits o All markets are expected to be at least weak for and semi-strong form efficient But not strong form In reality we’d expect that markets are inefficient enough to allow smart investors to make some $ o This assumes that investors are rational, but what if they aren’t? This explains recent “bubbles” If investors don’t rationally process information, markets may not accurately reflect even public information
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Unformatted text preview: • Problem: o Overconfidence of investors • Systematic risk and the market portfolio: o CAPM provides measure of individual security risk (not SD) o Market portfolio: Optimally diversified portfolio No unsystematic risk o Systematic vs. unsystematic risk: Systematic risk relates to risk of security related to the market/ external environment • Investment has a lot of unsystematic risk: o Low correlation w/ rest of portfolio Measurement of systematic risk: • Beta: o The slope of a straight line o On graph of stocks returns and those of a broad market index (like the S&P 500) o Higher beta means higher risk o Formula to calculate an entire portfolio’s beta o Higher beta, higher risk, higher required rate of return • Security market line: o Gives expected return for a stock...
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