Professional Documents
Culture Documents
Market Line
Financial Management
Outline
Risk of an investment
Expected return of an investment
Portfolios:
Portfolio expected returns
Portfolio risk
Risk: Systematic and Unsystematic Risk
Diversification and Portfolio Risk
The security market line and Capital
Asset Pricing Model
Defining Risk
Risk refers to the chance that some
unfavorable event will happen
Investment risk is the probability that
actual returns may deviate from
expected returns
The chance that actual returns may be
lower than expected return gives rise to
investment risk
Higher the probability of actual returns
being less than expected, higher will be
investment risk
Returns
Actual Return
Realized return/historical return/return ex-
post
Expected Return
Return ex-ante/anticipated return
A weighted average of all possible returns,
where weights represent probability of each
possible outcome
Multiply each possible outcome with its
probability and add them up over all
possible outcomes
Measuring Expected
Return
Examples
Coefficient of Variation
Standard deviation is an absolute
measure of risk
We cannot rank investments only on the
basis of standard deviation or on the
basis of expected return
To rank investments, we need a
measure of risk that is based on risk
and return
Coefficient of variation is a relative
measure of risk based on risk and
expected return
Risk and return are always
positively related
Higher return is associated with
high risk
Portfolio Risk and Return
Meaning of Portfolio
A combined holding of more than one stock,
bonds, real estate, or any other asset
Why create a portfolio?
To diversify/reduce/mitigate risk of a single
security
All securities in the portfolio may not move
together
If one goes down, others will go up and
compensate for the loss of the first one
Portfolio Expected Return
A simple weighted average of the expected
return of each security in the portfolio,
where weights represent the proportion of
investment in each portfolio
Examples
n
βp = Σ w i βi
i=1
Where wi represents proportion of total investment in
security i and βI represents beta of security i in the
portfolio
Examples
Security Market Line and
CAPM
Positive relationship between
systematic risk and return of a
portfolio
The line which gives the expected
returns-systematic risk
combinations of assets is called
the security market line