Lecture Handouts for Chapter 5
Chapter 5 is covered in lectures 31 and 32.
Risk and Return
The return from an investment is the change in market price, plus any cash payments received due to ownership, divided by the beginning price. The risk of a security can be viewed as the variability of returns from those that are expected.
Measurement of Risk
The expected return is simply a weighted average of the possible returns, with the weights being the probabilities of occurrence.
The conventional measure of dispersion, or variability, around an expected value is the standard deviation σ. The square of the standard deviation σ2 is known as the variance (σ2).
The standard deviation can sometimes be misleading in comparing the risk, or…show more content… Still, the CAPM serves as a useful theoretical framework for understanding risk and leads naturally to multiple factor models and the arbitrage pricing theory described in Appendix B to this chapter.
Efficient Financial Markets
Financial markets are said to be efficient when security prices fully reflect all available information. In such a market, security prices adjust very rapidly to new information.
Questions
1. If investors were not risk averse on average, but rather were either risk indifferent (neutral) or even liked risk, would the risk-return concepts presented in this chapter be valid?
2. Define the characteristic line and its beta.
3. Why is beta a measure of systematic risk? What is its meaning?
4. What is the required rate of return of a stock? How can it be measured?
5. Is the security market line constant over time? Why or why not?
6. What would be the effect of the following changes on the market price of a company’s stock, all other things the same?
a. Investors demand a higher required rate of return for stocks in general.
b. The covariance between the company’s rate of return and that for the market decreases.
c. The standard deviation of the probability distribution of rates of return for the company’s stock increases.
d. Market expectations of the growth of future earnings (and dividends) of the company are revised downward.
7. Suppose that you are highly risk