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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,*,*,11-,*,Return and Risk:The Capital Asset Pricing Model,Chapter 11,Copyright,2010 by the,McGraw-Hill Companies,Inc.All rights reserved.,McGraw-Hill/Irwin,Return and Risk:The Capital A,0,Key Concepts and Skills,Know how to calculate expected returns,Know how to calculate covariances,correlations,and betas,Understand the impact of diversification,Understand the systematic risk principle,Understand the security market line,Understand the risk-return tradeoff,Be able to use the Capital Asset Pricing Model,Key Concepts and SkillsKnow ho,1,Chapter Outline,11.1 Individual Securities,11.2 Expected Return,Variance,and Covariance,11.3 The Return and Risk for Portfolios,11.4 The Efficient Set for Two Assets,11.5 The Efficient Set for Many Assets,11.6 Diversification,11.7 Riskless Borrowing and Lending,11.8 Market Equilibrium,11.9 Relationship between Risk and Expected Return(CAPM),Chapter Outline11.1 Individual,2,11.1 Individual Securities,The characteristics of individual securities that are of interest are the:,Expected Return,Variance and Standard Deviation,Covariance and Correlation(to another security or index),11.1 Individual SecuritiesThe,3,11.2 Expected Return,Variance,and Covariance,Consider the following two risky asset world.There is a 1/3 chance of each state of the economy,and the only assets are a stock fund and a bond fund.,11.2 Expected Return,Variance,4,Expected Return,Expected Return,5,Expected Return,Expected Return,6,Variance,Variance,7,Variance,Variance,8,Standard Deviation,Standard Deviation,9,Covariance,“Deviation”compares return in each state to the expected return.,“Weighted”takes the product of the deviations multiplied by the probability of that state.,Covariance“Deviation”compare,10,Correlation,Correlation,11,11.3 The Return and Risk for Portfolios,Note that stocks have a higher expected return than bonds and higher risk.Let us turn now to the risk-return tradeoff of a portfolio that is 50%invested in bonds and 50%invested in stocks.,11.3 The Return and Risk for P,12,Portfolios,The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:,PortfoliosThe rate of return o,13,Portfolios,The,expected,rate of return on the portfolio is a weighted average of the,expected,returns on the securities in the portfolio.,PortfoliosThe expected rate of,14,Portfolios,The variance of the rate of return on the two risky assets portfolio is,where,BS,is the correlation coefficient between the returns on the stock and bond funds,.,PortfoliosThe variance of the,15,Portfolios,Observe the decrease in risk that diversification offers.,An equally weighted portfolio(50%in stocks and 50%in bonds)has less risk than either stocks or bonds held in isolation.,PortfoliosObserve the decrease,16,11.4 The Efficient Set for Two Assets,We can consider other portfolio weights besides 50%in stocks and 50%in bonds.,100%bonds,100%stocks,11.4 The Efficient Set for Two,17,The Efficient Set for Two Assets,100%stocks,100%bonds,Note that some portfolios are“better”than others.They have higher returns for the same level of risk or less.,The Efficient Set for Two Asse,18,Portfolios with Various Correlations,100%bonds,return,100%stocks,=0.2,=1.0,=-1.0,Relationship depends on correlation coefficient,-1.0,r,+1.0,If,r,=+1.0,no risk reduction is possible,If,r,=,1.0,complete risk reduction is possible,Portfolios with Various Correl,19,11.5 The Efficient Set for Many Securities,Consider a world with many risky assets;we can still identify the,opportunity set,of risk-return combinations of various portfolios.,return,P,Individual Assets,11.5 The Efficient Set for Man,20,The Efficient Set for Many Securities,The section of the opportunity set above the minimum variance portfolio is the efficient frontier.,return,P,minimum variance portfolio,efficient frontier,Individual Assets,The Efficient Set for Many Sec,21,Announcements,Surprises,and Expected Returns,The return on any security consists of two parts.,First,the expected returns,Second,the unexpected or risky returns,A way to write the return on a stock in the coming month is:,Announcements,Surprises,and,22,Announcements,Surprises,and Expected Returns,Any announcement can be broken down into two parts,the anticipated(or expected)part and the surprise(or innovation):,Announcement=Expected part+Surprise.,The expected part of any announcement is the part of the information the market uses to form the expectation,R,of the return on the stock.,The surprise is the news that influences the unanticipated return on the stock,U,.,Announcements,Surprises,and,23,Diversification and Portfolio Risk,Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns.,This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns fr
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