# FINS1613 Lecture Notes - Lecture 6: Systematic Risk, Risk Premium, Expected Return

Chapter 12: Systematic Risk and the Equity Risk Premium

How to measure systematic risk to compute expected return

- portfolio: collection of securities- securities in portfolio + amount invested in each

security

- return of a portfolio is a weighted avg of returns on indiv securities (% of total value)

o RP= A*RA + B*RB +… *R

o R(%) and A + B +… = 1

- Volatility of a portfolio- total risk measured as SD

o Combining shares into a portfolio reduces risk through diversification

o Amount of risk that is eliminated in a portfolio depends upon the degree to

which the shares face common risks and move together

▪ Correlation: measure of the degree to which returns share common

risk- covariance of the returns ÷ by product of SD of each return [-1:1]

- Risk benefit is the correlation coefficient p(ab) [-1:1]

- Without p- means no risk benefit from building portfolio

- Worst case: no benefit to building a portfolio p=1

- The expected return of a portfolio = weighted avg expected return of its shares, but

the volatility of a portfolio is less than the weighted avg volatility- ie eliminate some

volatility by diversifying

- There is a direct and proportional relationship between risk and return for large portfolios.

Returns increase in a consistent manner with the level of risk.

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## Document Summary

Chapter 12: systematic risk and the equity risk premium. How to measure systematic risk to compute expected return. Risk benefit is the correlation coefficient p(ab) [-1:1] Without p- means no risk benefit from building portfolio. Worst case: no benefit to building a portfolio p=1. The expected return of a portfolio = weighted avg expected return of its shares, but the volatility of a portfolio is less than the weighted avg volatility- ie eliminate some volatility by diversifying. There is a direct and proportional relationship between risk and return for large portfolios. Returns increase in a consistent manner with the level of risk. Value weighted portfolio: portfolio in which each security is held in proportion to its market cap. Market proxy: a portfolio whose return is believed to closely track the true market portfolio. Market index: market value of a broad-based portfolio of securities. Return to systematic risk should always be the same.