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Risk and Return

Systematic and Unsystematic Risk

We have stated that combining securities that are not perfectly, positively correlated helps to lessen the risk of a portfolio. How much risk reduction is reasonable to expect, and how many different security holdings in a portfolio would be required?

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The Capital-Asset Pricing Model (CAPM)

Based on the behavior of risk-averse investors, there is an implied equilibrium relationship between risk and expected return for each security. In market equilibrium, a security is supposed to provide an expected return commensurate with its systematic risk - the risk that cannot be avoided by diversification. The greater the systematic risk of a security, the greater the return that investors will expect from the security. The relationship between expected return and systematic risk, and the valuation of securities that follows, is the essence of Nobel laureate William Sharpe's capital-asset pricing model (CAPM). This model was developed in the 1960s, and it has had important implications for finance ever since. Though other models also attempt to capture market behavior, the CAPM is simple in concept and has real-world applicability.

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The Characteristic Line

We are now in a position to compare the expected return for an individual stock with the expected return for the market portfolio. In our comparison, it is useful to deal with returns in excess of the risk-free rate, which acts as a benchmark against which the risky asset returns are contrasted. The excess retrrrr is simply the expected return less the risk-free return.

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An lndex of Systematic Risk

A measure that stands out, and the most important one for our purposes, is beta. Beta is simply the slope (i.e., the change in the excess return on the stock over the change in excess return on the market portfolio) of the characteristic line. If the slope is 1.0, it means that excess returns for the stock vary proportionally with excess returns for the market portfolio.

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