In this chapter, students will be able to understand: Understand how ‘risk’ and ‘return’ are defined and measured, understand the concept of risk-aversion by investors, explain how diversification reduces risk, understand the importance of covariance between returns on assets in determining the risk of a portfolio,. | Chapter 7 Portfolio Theory and Asset Pricing 2 2 2 2 2 2 2 2 2 2 Learning Objectives Understand how ‘risk’ and ‘return’ are defined and measured. Understand the concept of risk-aversion by investors. Explain how diversification reduces risk. Understand the importance of covariance between returns on assets in determining the risk of a portfolio. 2 2 2 2 2 2 2 2 2 2 Learning Objectives (cont.) Explain the concept of efficient portfolios. Explain the distinction between systematic and unsystematic risk. Explain why systematic risk is important to investors. Explain the relationship between returns and risk proposed by the capital asset pricing model. 3 3 3 3 3 3 3 3 3 3 Learning Objectives (cont.) Understand the relationship between the capital asset pricing model and the arbitrage pricing model. Explain the development of the Fama–French three-factor model. 4 4 4 4 4 4 4 4 4 4 Return There is uncertainty associated with returns from shares. Assume we can assign probabilities . | Chapter 7 Portfolio Theory and Asset Pricing 2 2 2 2 2 2 2 2 2 2 Learning Objectives Understand how ‘risk’ and ‘return’ are defined and measured. Understand the concept of risk-aversion by investors. Explain how diversification reduces risk. Understand the importance of covariance between returns on assets in determining the risk of a portfolio. 2 2 2 2 2 2 2 2 2 2 Learning Objectives (cont.) Explain the concept of efficient portfolios. Explain the distinction between systematic and unsystematic risk. Explain why systematic risk is important to investors. Explain the relationship between returns and risk proposed by the capital asset pricing model. 3 3 3 3 3 3 3 3 3 3 Learning Objectives (cont.) Understand the relationship between the capital asset pricing model and the arbitrage pricing model. Explain the development of the Fama–French three-factor model. 4 4 4 4 4 4 4 4 4 4 Return There is uncertainty associated with returns from shares. Assume we can assign probabilities to the possible returns — given an assumed set of circumstances, the expected return is given by: 5 5 5 5 5 5 5 5 5 5 Expected Return Calculation Distribution of returns for security Percentage Return, Ri Probability, Pi 9 10 11 12 13 6 6 6 6 6 6 6 6 6 6 Risk Risk is present whenever investors are not certain about the outcome an investment will produce. Risk is measured in terms of how much a particular return deviates from an expected return, measured by variance: We often use standard deviation to measure risk. This is simply the square root of the variance. 7 7 7 7 7 7 7 7 7 7 Risk Calculation Continuing with the previous example, risk is given by: 8 8 8 8 8 8 8 8 8 8 Risk Attitudes Risk-neutral investor: One whose utility is unaffected by risk and hence, when choosing an investment, focuses only on expected return. Risk-averse investor: One who demands compensation in the form of higher expected returns in order to be induced into taking on more risk. .
