Download Components of total risk

Components of total risk -­‐ Total risk of a security may be decomposed into two parts: o Unique / Specific Risk – Risk factors affecting only that firm (can be diversified away). § Also known as Firm-­‐Specific Risk, Idiosyncratic Risk, Unsystematic Risk, Diversifiable Risk. o Market Risk – Economy-­‐wide sources of risk that affect overall stock market (cannot be diversified away) § Also known as Systematic Risk, Undiversifiable or Non-­‐Diversifiable Risk. -­‐ Important implication; A well-­‐diversified portfolio is exposed to market risk alone. Market risk of a well-­‐diversified portfolio is determined by the market risk of its component securities. -­‐ Measurement of market risk – Measuring how sensitive the security’s return is to market movements [i.e. the security’s beta (β)]. o The beta of a security measures the responsiveness of the security’s return to the overall market return. o In a statistical sense, beta tells us the tendency of an individual security’s return to co-­‐vary with the market portfolio. o Security’s beta = covariance with market (σim) / variance of market (σ2m). It is usually written as βi. o Interpretation of β: § β = 1 – security price changes one-­‐for-­‐one with overall market movements or the market portfolio. § 0 < β < 1 – security price changes in the same direction as the market overall but not as far. § β > 1 – security prices changes by more than market portfolio. Markowitz Portfolio Theory and normality -­‐ If returns are normally distributed, they are completely described by their mean and variance. So investors can choose portfolios based solely on the mean and variance. Thus, investors will prefer portfolios with high means and low variances. o If two stocks have the same expected return but different standard deviations of return, investors will prefer the stock with the smaller standard deviation of return. (Prefer less risk). o If two stocks have the same standard deviation of return but different expected returns, investors will prefer the stock with the larger expected return. (Prefer more return). § These statements are referred to as dominance principle. -­‐ An indifference curve plots the combination of risk-­‐return pairs than an investor would accept to maintain a given level of utility. o Risk averse investors prefer a high mean and a low standard deviation. -­‐ Portfolios that satisfy the mean-­‐variance criterion are also known as the set of efficient portfolios. -­‐ Markowitz Portfolio Theory – Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation. o Correlation coefficients make this possible. (See calculations above). o By changing the proportion of funds invested in stocks, one can change the risk-­‐return characteristics of a portfolio. o Efficient portfolios provide the highest return for a given level of risk or least risk for given level of returns. Relationship between risk and return -­‐ The ratio of the risk premium to the standard deviation is called the Sharpe Ratio. Sharpe Ratio =
rp − rf
σp
-­‐ Suppose there exist N basic assets and we form different portfolios from these assets using every possible weighting scheme i.e. we let weighting coefficients range over all possible combinations. o When these are plotted in mean-­‐standard deviation space, the set of points that correspond to these portfolios is called the feasible set or feasible region.