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Week 7-8:Chap 13: Return, Risk, and the Security Market Line

by: Nj

Week 7-8:Chap 13: Return, Risk, and the Security Market Line FIN 331

Marketplace > Towson University > Finance > FIN 331 > Week 7 8 Chap 13 Return Risk and the Security Market Line
Principles Financial Management
Moon-Whoan Rhee

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Principles Financial Management
Moon-Whoan Rhee
Class Notes
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This 4 page Class Notes was uploaded by Nj on Thursday October 22, 2015. The Class Notes belongs to FIN 331 at Towson University taught by Moon-Whoan Rhee in Summer 2015. Since its upload, it has received 32 views. For similar materials see Principles Financial Management in Finance at Towson University.


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Date Created: 10/22/15
Chapter 13 Return Risk and the Security Market Line 2 types of risk systematic affects almost all assets in the economy also called nondiversifiable or market risk unsystematic affects at most a small number of assets also called diversifiable risk unique risk or assetspeci c risk Highly diversi ed portfolios tend to have almost no unsystematic risk Expected projected return is the return on a risky asset expected in the future Ex suppose you have predicted the following returns for stocks C and T in 3 possible states of the economy What are the projected return m Probability Q I Boom 03 015 025 Normal 05 010 020 Recession 002 001 probability 02 because 0305 must be 01 ERc 03 x 15 05 x 10 02 x 2 99 ERT 03 x 25 05 x 20 02 x 1 177 Risk premium Expected return Risk free rate Variance and Standard deviation If 1 variance sqrtlquot2square root of 1quot2 standard deviation EX State Probability ABC Inc Boom 025 015 Normal 050 008 Slowdown 015 004 Recession 010 003 ER 025 x 15 05 x 8 015 x 4 010 x 3 805 Variance 025 x 15805quot2 05 x 8805quot2 015 x 4805quot2 010 x 3805quot2 000267475 Standard deviation 025 x 15805 05 x 8805 015 x 4 805 010 x 3805 517 Portfolios A portfolio is a collection more than a single stock bonds or other asset of assets Diversi cation the process of spreading an investment across assets and thereby forming a portfolio The principle of diversi cation tells us that spreading an investment across many assets will eliminate some of the risks Because unsystematic risk can be eliminated at virtually no cost by diversifying there is no reward for bearing it means the market does not reward risks that are borne unnecessarily Risk return measured by the portfolio expected return and standard deviation just as with individual assets Ex expected portfolio return Consider the portfolio weights computed previously If the individual stocks have the following expected returns what is the expected return for the portfolio C 1969 KO 525 INTC 1665 BP 1824 ERP 1331969 2525 2671665 41824 1541 Security market lineSML line we use to describe the relationship between systematic risk and expected return in nancial markets Portfolio variance Compute the portfolio return for each state RP wlR1 W2R2 mem Compute the expected portfolio return using the same formula as for an individual asset Compute the portfolio variance and standard deviation using the same formulas as for an individual asset Ex Consider the following information on returns and probabilities Invest 50 of your money in Asset A State Probability A B Portfolio Boom 4 30 5 125 Bust 6 10 25 75 What are the expected return and standard deviation for each asset What are the expected return and standard deviation for the portfolio If A and B are your only choices What percent are you investing in Asset B 50 Asset A ERA 430 6 10 6 VarianceA 430 62 6 10 62 384 Std DeVA 196 Asset B ERB 4 5 625 13 VarianceB 4 5 132 625 132 216 Std DeVB 147 Portfolio solutions to portfolio return in each state appear with mouse click after last question Portfolio return in boom 530 55 125 Portfolio return in bust 510 525 75 Expected return 4125 675 95 or Expected return 56 513 95 Variance of portfolio 4025952 675 952 6 Standard deviation 245 Note that the variance is NOT equal to 5384 5 216 300 and Standard deviation is NOT equal to 5196 5147 1717 What would the expected return and standard deviation for the portfolio be if we invested 37 of our money in A and 47 in B Portfolio return 10 and standard deviation 0 Portfolio variance using covariances COVAB 430 6 5 13 6 10 625 13 288 Variance of portfolio 52384 52216 255 288 6 Standard deviation 245


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