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Unformatted text preview: e of expected returns between a stock and the market portfolio and the variance of
market portfolio to compute the beta, practitioners typically use the SIM to estimate the beta of a stock, on
the assumption that market index is representative of the benchmark market portfolio proposed by CAPM. 13 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 S TOCK RESIDUAL RETURN
Residual Return captures the unexpected or abnormal returns, explained by firm-specific returns such as news
on capital restructuring and earnings. The random nature of these events means that the average residual
return = 0. Since these events are firm specific and have no influence on the performance on other firms, the
SIM assumes that the residual returns of different companies are not correlated.
If a financial market is semi strong efficient, current stock prices should fully reflect all publicly known info
about the company, and stock prices will adjust to new information accurately and instantaneously.
C ALCULATING STOCK RESIDUAL RETURNS
Textbook page 118: T HE COMPONENTS OF RISK OF A STOCK
Two main types of risk: Systematic and Unsystematic.
Systematic risk is about deviation of observed return from that expected due to unanticipated macroeconomic events.
Unsystematic risk is defined as deviation of observed return due to unanticipated firm-specific events.
The variance of excess returns of stock i: 2 i2 i2 M 2
Where variance of m denotes the variance of excess market returns and variance of e denotes the variance of
residual returns or residual variance. 14 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 D IVERSIFICATION AND RISK REDUCTION IN THE CONTEXT OF SIM
If we re-use the above equation in the context of a portfolio with n
stocks, as follows: 2
22 P P M 2 P As residual retument (V0), 3 others can be derived: Total return earned over n periods = Value of investment (Vt) after n periods based on CCR = Value of investment (Vt) after n periods based on DR = (1+GAR)n – 1 = r...
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