SD of a 2 stock portfolio:
Correlation Coefficient/Covariance:
-1.0 ≤ ρ ≤ 1.0
If ρ=-1.0, 2 stocks can form a riskless
portfolio
If ρ=+1.0, there is no reduction of risk
for the 2 stock portfolio
Total Risk = Company-specific
(Unsystematic Risk) + Mkt
(Systematic) Risk
Unsystematic Risk:
caused by
random events specific to firm. Can be
diversified
Systematic Risk:
affects most if not
all firms. Cannot be diversified away.
β
measures stock’s market/systematic
risk, shows volatility relative to
market, indicating how risky a stock is
if held in a well-diversified portfolio.
Mkt β is 1.
β of risk-free asset = 0
AAR
: what you earned in a typical
year. (in 1yr AAR=GAR; as yields go
lower, AAR converges with GAR)
GAR:
what you actually earn per year
on average cpd annually. (aka mean

holding period return or avg cpd return
earned per year over a multi-year
period)
R&RII (β
,
CAPM, SML)
Risk-Return Trade-off
for a portfolio
is measured by portfolio’s expected
return & standard deviation (volatility
of the portfolio)
Diversification
involves investing in
different asset classes & sectors. It
reduces variability of returns without
equivalent reduction in expected
returns.
Well Diversified Portfolios
have very
little unsystematic risk. Risk =
systematic risk
Portfolio’s Beta, β
p
is the weighted
average of the assets betas.
Systematic Risk
Principle:
a reward for
bearing risk but
there is no reward
for bearing risk
unnecessarily.
Expected return on
a risky asset
depends only on β.
β>1 implies that
the asset has more
systematic risk
than the overall
market
Risk Premium = (R
M
– R
F
)β = E(R) –
R
f
Rate
Mkt Risk Premium = R
M
– R
F
(since
market β is always 1)
Reward-to-risk ratio
If RRR < mkt RRR ROR too low,
stock overpriced
e.g. if reward/risk ratio = 7.5%, Asset
A has a risk premium of 7.5% per
“unit” of sys risk
Mkt β=1, Rf β = 0
Security Mkt Line:
Graphical
representation of the CAPM, & market
equilibrium
Assets below SML are overpriced
& assets above SML are
underpriced
Capital Asset Pricing Model:
equation describing SML. Appropriate
return for risk
Capital Mkt Line:
the tangential line
joining the Risk Free Rate to the
efficient frontier of all possible
portfolios in the market
Security Mkt Line
Capital Mkt Line
Graphical representation of
market’s risk & return at a
given time
Shows rate of return, which
depend on risk free rate &
levels of risk of a specific
portfolio
Beta x-axis
Standard deviation x-axis
Both nonefficient & efficient
Only efficient portfolios
Where market portfolios & risk free
assets are determined by CML,
security factors are determined by
SML. CML is superior to SML in
measuring risk factors.
LECTURE 4: Risks & Returns I

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- Spring '11
- tohmunheng
- Generally Accepted Accounting Principles