Systematic

Risk risk

unsystematic

 Risk

factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc. market risk cannot be eliminated through diversification due to factors affecting all assets -- energy prices, interest rates, inflation, business cycles

The systematic risk is further divided into Market Risk Interest Rate Risk Purchasing Power Risk -Demand Pull Inflation -Cost Push Inflation

 Risk

factors that affect a limited number of assets Also known as unique risk and assetspecific risk Includes such things as labor strikes, part shortages, availability of raw materials etc. specific to a firm can be eliminated through diversification

Unsystematic Risk can be classified into Business Risk Financial Risk Business risk Internal Business Risk  Fluctuations in sales  R&D  Personnel Management  Fixed Costs  Single Product External Risk  Social & Regulatory Factors  Political Risk  Business Cycles

W unsystematic risk total risk systematic risk # assets

do we measure systematic risk? We use the beta coefficient to measure systematic risk What does beta tell us?
How

A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

 variation

in asset/portfolio return relative to return of market portfolio

mkt. portfolio = mkt. index -- S&P 500 or NYSE index

% change in asset return F= % change in market return

 if

F! F! F"

asset is risk free asset return = market return asset is riskier than market index asset is less risky than market index

if if


F 

Amazon Anheuser Busch Microsoft Ford General Electric Wal Mart

2.23 -.107 1.62 1.31 1.10 .80

 estimated

by regression

data on returns of assets data on returns of market index estimate

R ! E  FR m  I

Remember that the risk premium =

expected return risk-free rate

30 25 Expected Ret r 20 15 10
Rf

E(RA)

5 0 0 0.5 1 1.5 Bet

FA

2.5

 The

reward-to-risk ratio is the slope of the line illustrated in the previous example
Slope = (E(RA) Rf) / (FA 0) Reward-to-risk ratio for previous example = (20 8) / (1.6 0) = 7.5

What

if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)? What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?

 In

equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market

E ( RA )  R f FA

E ( RM  R f ) FM

security market line (SML) is the representation of market equilibrium The slope of the SML is the reward-to-risk ratio: (E(RM) Rf) / FM But since the beta for the market is ALWAYS equal to one, the slope can be rewritten Slope = E(RM) Rf = market risk premium
The

capital asset pricing model defines the relationship between risk and return E(RA) = Rf + FA(E(RM) Rf) If we know an assets systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets
The

 Pure

time value of money measured by the risk-free rate Reward for bearing systematic risk measured by the market risk premium Amount of systematic risk measured by beta

Consider the betas for each of the assets given earlier. If the risk-free rate is 2.13% and the market risk premium is 8.6%, what is the expected return for each?

Security DCLK KO INTC KEI

Beta 2.685 0.195 2.161 2.434

Expected Return 2.13 + 2.685(8.6) = 25.22% 2.13 + 0.195(8.6) = 3.81% 2.13 + 2.161(8.6) = 20.71% 2.13 + 2.434(8.6) = 23.06%

 variation

in asset/portfolio return relative to return of market portfolio

mkt. portfolio = mkt. index -- S&P 500 or NYSE index

% change in asset return F= % change in market return

 if

F! F! F"

asset is risk free asset return = market return asset is riskier than market index asset is less risky than market index

if

if

F 

Amazon Anheuser Busch Microsoft Ford General Electric Wal Mart

2.23 -.107 1.62 1.31 1.10 .80

(monthly returns, 5 years back)

 estimated

by regression

data on returns of assets data on returns of market index estimate

R ! E  FR m  I

 what

length for return interval? of market index?

weekly? monthly? annually?

choice

NYSE, S&P 500 survivor bias

of observations (how far back?)

5 years? 50 years?
time

period?

1970-1980? 1990-2000?

 CAPM

Capital Asset Pricing Model 1964, Sharpe, Linter quantifies the risk/return tradeoff

 investors

choose risky and risk-free asset no transactions costs, taxes same expectations, time horizon risk averse investors

 expected

return is a function of

beta risk free return market return

E( R ) ! R f  F[ E( R m )  R f ]
or

E( R )  R f ! F[ E( R m )  R f ]
where

E( R )  R f is the ortfolio risk remium

E(
m

)

is the market risk remium

E( R )  R f

>

E( R m )  R f

E( R ) > E( R m )
portfolio

exp. return is larger than exp. market

return riskier portfolio has larger exp. return

E( R )  R f

<

E( R m )  R f

E( R ) < E( R m )
portfolio

exp. return is smaller than exp. market

return less risky portfolio has smaller exp. return

E( R )  R f

E( R m )  R f

E( R ) = E( R m )
portfolio

exp. return is same than exp. market

return equal risk portfolio means equal exp. return

E( R )  R f

=0
Rf

E( R ) =
portfolio

exp. return is equal to risk free return