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Realized return =
e(return) + unexpected return
a collection of assets
The risk and return of a portfolio is
measured by expected return and standard deviation of returns
The percentage of a portfolio's total value that is in a particular asset.
drives the movement of the stock
Unexpected return =
systematic portion + unsystematic portion
Cannot be diversified and is relevant. Measured by beta. Beta determines the level of expected return on a security or portfolio (SML)
The risk that effects at most a small number of assets; it is also called unique or asset-specific risk. For example, oil strike by a single company.
investing in a portfolio whose returns do not always move together with the result that overall risk is lower than for individual assets ( You shouldn't put all your eggs in one basket)
Because there is a better chance of investing in a good stock
Why is the standard deviation lower if you invest in a greater number of stocks?
the component of a return that compensates for risk (credit risk premium compensates for borrower's risk)
How to measure systematic risk?
BETA - it gives a measure of how an assets return move with the systematic risk in the market
if B = 1
implies the asset has the same systematic risk as the overall market
if B < 1
implies the asset has less systematic risk than the overall market
if B> 1
implies the asset has more systematic risk than the overall market
if B = 0
movement of your asset is uncorrelated with the movement in the market
if B < 0
movement of your asset goes in the opposite direction to the movement of the market
Which stock should have the higher expected return between x and y
the one with the higher Beta, as it leads to a higher premium thus higher return
a model that simplifies a complex investment environment and which allows investors to understand the relationship between risk and return
Reward to risk ratio
is the slope of the security market line
All assets and portfolios must have the same reward to risk ratio and it must equal the reward to risk ratio of the market which in turn equals the market risk premium