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

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16 May 2018
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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 RP= A*RA + B*RB +… *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.

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