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Topic 03 - Risk and Return

This document defines key concepts related to risk and return. It discusses how to measure expected return, risk and variation through calculations of standard deviation and coefficient of variation. It also defines the concepts of portfolio, beta, characteristic line and how the Capital Asset Pricing Model relates risk and return. Specifically, it outlines how to calculate portfolio expected return and standard deviation, defines the CAPM assumptions, and explains that beta measures how an asset moves with the market while the characteristic line and security market line graphically represent CAPM.

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ravindu 11111
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45 views5 pages

Topic 03 - Risk and Return

This document defines key concepts related to risk and return. It discusses how to measure expected return, risk and variation through calculations of standard deviation and coefficient of variation. It also defines the concepts of portfolio, beta, characteristic line and how the Capital Asset Pricing Model relates risk and return. Specifically, it outlines how to calculate portfolio expected return and standard deviation, defines the CAPM assumptions, and explains that beta measures how an asset moves with the market while the characteristic line and security market line graphically represent CAPM.

Uploaded by

ravindu 11111
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Risk and Return

Learning Outcomes
At the end of the summary I will be able to ;
 Define risk and return and show how to measure them by calculating expected return,
standard deviation and coefficient of variation
 Define portfolio and measuring portfolio expected return and portfolio standard
deviation
 Explain the Capital Asset Pricing Model ( CAPM )
 Recognize the beta, characteristic line and security market line

Abstract

In this chapter I will study the risks and returns. It first identifies the risks and returns and
discusses how they are calculated. The return can be quantified relative to the risk of an asset.
It then discusses some of the key sections related to risks and returns. Finally, I hope to study
what a portfolio is, how to do the calculations associated with it, and the concept of beta.

Define risk and return and show how to measure them by calculating
expected return, standard deviation and coefficient of variation

Define Return

Income received on an investment plus any change in market price, usually expressed as a
percent of the beginning market price of the investment.

Define Expected Return

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Expected Return is the weighted average of possible returns, with the weights being the
probabilities of occurrence.

Discrete
distributions Continuous distributions

Define Risk

Risk is the variability between the expected returns and actual returns.

Risk

Systematic Risk
Unsystematic Risk
- These risks are applicable to all sectors - These risks are associated with specific
security, firm or industry
- Can't be controlled
- Can be controlled
- Allocation of the assets
- Diversification of the portfolio
- Interest risk and Market risk
- Financial and Business specific risk

Standard Deviation

The standard deviation is a measure of the amount of variation or dispersion of a set of values.

Discount distribution
Continuos distribution

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Coefficient of Variation
The coefficient of variation is the ratio of the standard deviation to the mean.

 The lower the coefficient of variation, the lower the risk.


 The higher the coefficient of variation, the higher the risk.

Define portfolio and measuring portfolio expected return and portfolio


standard deviation
What is portfolio ?

A portfolio is a collection of investment or financial assets such as stocks and bonds of an


individual or entity.

Portfolio expected return

The value obtained by multiplying the weight of each asset by the expected return and adding
value to each investment is called the expected return n the portfolio.

Portfolio standard deviation

Covariance

Correlation coefficient
A measure of the linear correlation between two variables.

Perfect negative correlation -1

No correlation 0
Perfect positive correlation +1

Explain the Capital asset Pricing Model ( CAPM )

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Capital asset pricing model shows the relationship between systematic risk and expected
return on assets.

CAPM Assumptions

 Maximize economic utilities is the aim of all investors


 Homogeneous expectations
 No transaction fee
 Assets are divisible
 Risk-free asset return is certain

Recognize the beta, characteristic line and security market line

What is the beta ?


A beta is a measure of how a single asset moves as the overall stock market fluctuates.

Characteristic line
This is a regression line, a straight line that summarizes the risk and return ratio, always
planning specific defenses against the market portfolio.
Security market line
The graphical representation of the capital asset pricing model is called the security market
line. The relationship between the risks of a security, measurable by its beta coefficient, and
the returns that one can expect from it at every level of risk.
Identify efficient financial market
Market efficiency is the level at which market information reflects relevant information.
There are three types of market efficiency,
1) Weak form efficiency – Current information is represented by stock prices, and it is
believed that past information has nothing to do with current market prices.
2) Semi-strong form efficiency – The belief here is that only general
information( economic & accounting) is represented by stock prices.
3) Strong form efficiency – This means that all public and private information is
reflected in the share price.

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Summary
 Return means income received on an investment plus any change in market price.

 Risk means the variability of returns from those that are expected. Risks are mainly
two part, 1) Systematic risk
2) Unsystematic risk
 Expected return

 Standard deviation

 Coefficient of variation

 Portfolio expected return

 Portfolio standard deviation

 Covariance

 CAPM is a model that describes the relationship


between risk and expected return
 Beta is an index of systematic risk
 A characteristic line is a straight line formed using regression analysis that summarizes
a particular security’s systematic risk and rate of return.
 The CPM is graphically represented by drawing the security market line.
 Market efficiency are three types,
1) Weak form
2) Semi-strong form
3) Strong form

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