CHAPTER 18 Return, Risk, and the Security Market Line An important insight of modern financial theory is that some investment risks yield an expected reward, while other risks do not. Essentially, risks that can be eliminated by diversification do not yield an expected reward, and risks that cannot be eliminated by diversification | CHAPTER 18 Return Risk and the Security Market Line An important insight of modern financial theory is that some investment risks yield an expected reward while other risks do not. Essentially risks that can be eliminated by diversification do not yield an expected reward and risks that cannot be eliminated by diversification do yield an expected reward. Thus financial markets are somewhat fussy regarding what risks are rewarded and what risks are not. Chapter 1 presented some important lessons from capital market history. The most noteworthy perhaps is that there is a reward on average for bearing risk. We called this reward a risk premium. The second lesson is that this risk premium is positively correlated with an investment s risk. In this chapter we return to an examination of the reward for bearing risk. Specifically we have two tasks to accomplish. First we have to define risk more precisely and then discuss how to measure it. Once we have a better understanding of just what we mean by risk we will go on to quantify the relation between risk and return in financial markets. When we examine the risks associated with individual assets we find there are two types of risk systematic and unsystematic. This distinction is crucial because as we will see systematic risk affects almost all assets in the economy at least to some degree whereas unsystematic risk affects at most only a small number of assets. This observation allows us to say a great deal about the risks and returns on individual assets. In particular it is the basis for a famous relationship between risk 2 Chapter 18 and return called the security market line or SML. To develop the SML we introduce the equally famous beta coefficient one of the centerpieces of modern finance. Beta and the SML are key concepts because they supply us with at least part of the answer to the question of how to go about determining the expected return on a risky investment. Announcements Surprises and Expected Returns
