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Chapter 8

Introduction to Risk and Return

Book Version 3
By Boundless
Boundless Finance
Finance
by Boundless
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Section 1
Understanding Return
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Expected Return

In probability theory, the expected value of a random variable is the weighted average of all possible values.

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Variance

Variance is a statistical concept describing the range around expected return within which an investment return can be reasonably expected to fall.

Section 2
Portfolio Considerations
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Portfolio Diversification and Weighting

Weighting is the percent allocation a particular investment type receives within a portfolio.

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Implications for Expected Returns

The expected return of a diversified portfolio is the expected return of each of its underlying investments times the weight the investment receives.

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Implications for Variance

A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a single asset portfolio.

Section 3
The Impact of News of Expected Returns
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Surprises and Returns

Surprise announcements can trigger a chain of events that affect the stock price of a particular company by changing investor expectations.

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Announcements, News, and Returns

The Value of a Company.

Section 4
Risk
Types of Risk

There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.

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Measuring Risk

The higher the risk undertaken, the more ample the expected return and the lower the risk, the more modest the expected return.

Section 5
Implications Across Portfolios
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Calculating Expected Portfolio Returns

A portfolio's expected return is the sum of the weighted average of each asset's expected return.

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Portfolio Risk

The risk in a portfolio is measured as the amount of variance that investors can expect based on historical data.

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Beta Coefficient for Portfolios

A portfolio's Beta is the volatility correlated to an underlying index.

Section 6
Diversification
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Impact of Diversification on Risk and Return: Unsystematic Risk

In general, diversification can reduce risk without negatively impacting expected return.

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Impact of Diversification on Risk and Return: Systematic Risk

Systematic risk is intrinsic to the market, and thusly diversification has no effect on its presence in investments.

Section 7
Understanding the Security Market Line
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Expected Risk and Risk Premium

Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.

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Defining the Security Market Line

The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.

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Impact of the SML on the Cost of Capital

The plotted location of an instrument on the SML has consequences on its price, return, and cost of capital it contributes to a firm.

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Boundless Finance by Boundless
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Stock Valuation
  • Defining Stock
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Chapter 8
Introduction to Risk and Return
  • Understanding Return
  • Portfolio Considerations
  • The Impact of News of Expected Returns
  • Risk
  • Implications Across Portfolios
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Security Market Efficiency and Returns
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