SD of a 2 stock portfolio Correlation 10 \u03c1 10 If \u03c1 10 2

# Sd of a 2 stock portfolio correlation 10 ρ 10 if ρ

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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