Chpt 10 pt 2

Stand-alone = Portfolio + Diversifiable
risk risk r isk

Two of the most important financial analysis concepts are risk and return.

What is financial risk, how is it measured, and why is it so important to financial decision making?

The risk of a portfolio (sp) -------- as more and more investments are randomly added.

The risk of a portfolio (sp) decreases as more and more investments are randomly added.
However, the incremental risk reduction from each new investment decreases as more assets are added.
Considerable risk remains regardless of the number of assets added.

However, the incremental risk reduction from each new investment --- as more assets are added.

Considerable risk remains regardless of the number of assets added.

Stand-alone risk is the risk of an individual investment when it is held in ------.

Diversifiable risk is that part of the stand-alone risk that can be eliminated by diversification.

Stand-alone risk is the risk of an individual investment when it is held in isolation.

Diversifiable risk is that part of the stand-alone risk that can be eliminated by -------

what cannot be eliminated by diversification?

It is --- rationale for an investor, whether an individual or business, to hold a single investment.

It is not rationale for an investor, whether an individual or business, to hold ---------

It is not rationale for an investor, whether an individual or business, to hold a single investment.

Because an investment held in a portfolio is less risky than when held in isolation,

stand-alone risk measures (i.e., s) are not relevant for investments held in portfolios.

Because an investment held in a -------- is less risky than when held in isolation,

The most widely used measure of risk

The most widely used measure of risk for investments held in portfolios is the beta coefficient, or just beta.
Beta measures the volatility of the investment’s returns relative to the returns on the portfolio.
Because beta is a relative measure of risk, it depends on both the investment and the portfolio.

If beta = 1.0, investment has average risk, where average is defined as the riskiness of the portfolio.
If beta > 1.0, investment has above-average risk.
If beta < 1.0, investment has below-average risk.
Most investments have betas in the range of 0.5 to 1.5.

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If beta < 1.0.........

Most investments have betas in the range of ---- to 1.5.

The CAPM is based on a very ________ set of assumptions.
It has not been empirically verified.
It is based on investor expectations, but the inputs used in the model typically are based on historical data.

CAPM It is based on investor expectations, but the inputs used in the model typically are based on ---- data.

Some Good News About the CAPM

The CAPM provides investors with a very ------ way of thinking about required rates of return..
R(Re) is composed of:
The risk-free rate, which compensates investors for the time value of money.
A risk premium, which compensates investors for the amount of portfolio risk assumed.

The ---------- which compensates investors for the time value of money.
A risk premium, which compensates investors for the amount of portfolio risk assumed.

Portfolio Risk

If the investor is an individual, the investments are individual --------- (stocks), the portfolio is the market portfolio, and the relevant risk of each asset is called market risk.
If the investor is a business, the investments are real assets (projects), the portfolio is the entire business, and the relevant risk of each asset is called corporate risk .

If the investor is a business, the investments are ------- assests which are known as -------

In for-profit businesses, projects have both corporate risk and market risk.
The risk of the project as seen by the business’s managers is corporate risk, which is measured by its corporate beta.
The risk of the project as seen by the business’s shareholders is market risk, which is measured by market beta.

The risk of the project as seen by the business’s managers is corporate risk, which is measured by its corporate beta.

what is measured by market beta

The beta of portfolio is simply the weighted average of the betas of the component investments.

Risk and Required Return

Defining and measuring risk is of ------ value if we cannot relate risk to required rate of return.