FUNDAMENTAL FINANCIAL CONCEPTS
OF RISK, RETURN AND VALUE
OBJECTIVES
UNDERSTAND THE MEANING AND FUNDAMENTALS OF RISK, RETURN AND RISK
AVERSION.
DESCRIBE PROCEDURES FOR ASSESSING AND MEASURING THE RISK OF A SINGLE
ASSET.
RISK MEASUREMENT FOR A SINGLE ASSET USING THE STANDARD DEVIATION AND
COEFFICIENT OF VARIATION
UNDERSTAND THE RISK AND RETURN CHARACTERISTICS OF A PORTFOLIO IN TERMS OF
CORRELATION AND DIVERSIFICATION, AND THE IMPACT OF INTERNATIONAL ASSETS ON
A PORTFOLIO.
REVIEW THE TWO TYPES OF RISK AND THE DERIVATION AND ROLE OF BETA IN
MEASURING THE RELEVANT RISK OF BOTH AN INDIVIDUAL SECURITY AND A PORTFOLIO.
EXPLAIN THE CAPITAL ASSET PRICING MODEL (CAPM) AND ITS RELATIONSHIP TO THE
SECURITY MARKET LINE (SML).
RISK
RETURN
HISTORICAL RETURN
INVESTMENT RETURNS VARY BOTH OVER TIME AND BETWEEN DIFFERENT TYPES
OF INVEST- MENTS. BY AVERAGING HISTORICAL RETURNS OVER A LONG PERIOD OF
TIME, IT IS POSSIBLE TO ELIMINATE THE IMPACT OF MARKET AND OTHER TYPES OF
RISK.
RISK AVERSION
THE ATTITUDE TOWARD RISK IN WHICH AN INCREASED RETURN IS REQUIRED
FOR AN INCREASE IN RISK.
ACCORDINGLY, A RISK-AVERSE FINANCIAL MANAGER REQUIRING HIGHER
RETURN FOR GREATER RISK IS ASSUMED THROUGHOUT THIS TEXT.
RISK OF A SINGLE ASSET
RISK ASSESSMENT
SENSITIVITY ANALYSIS
AN APPROACH FOR ASSESSING RISK THAT USES SEVERAL POSSIBLE-RETURN
ESTIMATES TO OBTAIN A SENSE OF THE VARIABILITY AMONG OUTCOMES.
RANGE
A MEASURE OF AN ASSETS RISK, WHICH IS FOUND BY SUBTRACTING THE
PESSIMISTIC (WORST) OUTCOME FROM THE OPTIMISTIC (BEST) OUTCOME.
PROBABILITY DISTRIBUTIONS
PROBABILITY DISTRIBUTIONS PROVIDE A MORE QUANTITATIVE
INSIGHT INTO AN ASSETS RISK.
PROBABILITY - THE CHANCE THAT A GIVEN OUTCOME WILL
OCCUR.
PROBABILITY DISTRIBUTION
A MODEL THAT RELATES PROBABILITIES TO THE ASSOCIATED OUTCOMES.
BAR CHART- THE SIMPLEST TYPE OF PROBABILITY DISTRIBUTION; SHOWS
ONLY A LIMITED NUMBER OF OUTCOMES AND ASSOCIATED PROBABILITIES
FOR A GIVEN EVENT.
CONTINUOUS PROBABILITY DISTRIBUTION- A PROBABILITY DISTRIBUTION
SHOW- ING ALL THE POSSIBLE OUTCOMES AND ASSOCIATED PROBABILITIES
FOR A GIVEN EVENT.
RISK MEASUREMENT
TWO STATISTICS
STANDARD DEVIATION
COEFFICIENT OF VARIATION
STANDARD DEVIATION
THE MOST COMMON STATISTICAL INDICATOR OF AN ASSETS RISK; IT MEASURES THE
DISPERSION AROUND THE EXPECTED VALUE.
HISTORICAL RETURNS AND RISK
COEFFICIENT OF VARIATION
A MEASURE OF RELATIVE DISPERSION THAT IS USEFUL IN
COMPARING THE RISKS OF ASSETS WITH DIFFERING EXPECTED
RETURNS.
RISK OF A PORTFOLIO
EFFICIENT PORTFOLIO- A PORTFOLIO THAT MAXIMIZES RETURN FOR A GIVEN LEVEL OF RISK OR MINIMIZES RISK
FOR A GIVEN LEVEL OF RETURN.
CORRELATION - A STATISTICAL MEASURE OF THE RELATIONSHIP BETWEEN ANY TWO SERIES OF NUMBERS
REPRESENTING DATA OF ANY KIND.
POSITIVELY CORRELATED
NEGATIVELY CORRELATED
CORRELATION COEFFICIENT
PERFECTLY POSITIVELY CORRELATED
PERFECTLY NEGATIVELY CORRELATED
DIVERSIFICATION
THE CONCEPT OF CORRELATION IS ESSENTIAL TO DEVELOPING
AN EFFICIENT PORTFOLIO. TO REDUCE OVERALL RISK, IT IS BEST
TO COMBINE, OR ADD TO THE PORTFOLIO, ASSETS THAT HAVE A
NEGATIVE (OR A LOW POSITIVE) CORRELATION.
COMBINING NEGATIVELY CORRELATED ASSETS TO DIVERSIFY RISK
UNCORRELATED
RISK AND RETURN: THE CAPITAL ASSET
PRICING MODEL (CAPM)S
THE BASIC THEORY THAT LINKS RISK AND RETURN FOR ALL ASSETS.
TYPES OF RISK
TOTAL RISK - THE COMBINATION OF A SECURITYS NONDIVERSIFIABLE
RISK AND DIVERSIFIABLE RISK
DIVERSIFIABLE RISK - THE PORTION OF AN ASSETS RISK THAT IS
ATTRIBUTABLE TO FIRM-SPECIFIC, RANDOM CAUSES; CAN BE ELIMINATED
THROUGH DIVERSIFICATION. ALSO CALLED UNSYSTEMATIC RISK.
NON DIVERSIFIABLE RISK - THE RELEVANT PORTION OF AN ASSETS RISK
ATTRIBUTABLE TO MARKET FACTORS THAT AFFECT ALL FIRMS; CANNOT BE
ELIMINATED THROUGH DIVERSIFICATION. ALSO CALLED SYSTEMATIC RISK.
THE
COEFFICIENTCAPM
BETAMODEL:
A RELATIVE MEASURE OF NONDIVERSIFIABLE RISK. AN INDEX OF THE
DEGREE OF MOVEMENT OF AN ASSETS RETURN IN RESPONSE TO A
CHANGE IN THE MARKET RETURN.
DERIVING BETA FROM RETURN DATA
AN ASSETS HISTORICAL RETURNS ARE USED IN FINDING THE ASSETS
BETA COEFFICIENT.
INTERPRETING BETAS
PORTFOLIO BETAS
THE EQUATION
Risk-free rate of interest
U.S. Treasury bills (T-bills)
HISTORICAL RISK PREMIUMS
THE GRAPH: THE SECURITY MARKET LINE (SML)
THE DEPICTION OF THE CAPITAL ASSET PRICING MODEL (CAPM ) AS A
GRAPH THAT REFLECTS THE REQUIRED RETURN IN THE MARKETPLACE
FOR EACH LEVEL OF NONDIVERSIFIABLE RISK (BETA).
EFFICIENT MARKET
A MARKET WITH THE FOLLOWING CHARACTERISTICS:
MANY SMALL INVESTORS,
ALL HAVING THE SAME INFORMATION AND EXPECTATIONS WITH
RESPECT TO SECURITIES;
NO RESTRICTIONS ON INVESTMENT, NO TAXES, AND NO
TRANSACTION COSTS;
AND RATIONAL INVESTORS, WHO VIEW SECURITIES SIMILARLY AND
RISK- AVERSE, PREFERRING HIGHER RETURNS AND LOWER RISK.
THANK YOU
