The Meaning and Measurement of Risk and Return
In this chapter, we examine the factors that determine rates of return (discount rates) in the capital markets. We are particularly interested in the relationship between risk and rates of return. We look at risk both in terms of the riskiness of an individual security and that of a portfolio of securities.
I. Expected Return Defined and Measured
A. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates.
B. Conventionally, we measure the expected cash flow, [pic], as follows:
[pic] = [pic]XiP(Xi)
where n = …show more content…
C. Total variability can be divided into:
a. The variability of returns unique to the security (diversifiable or unsystematic risk)
b. The risk related to market movements (nondiversifiable or systematic risk)
D. By diversifying, the investor can eliminate the "unique" security risk. The systematic risk, however, cannot be diversified away.
E. Measuring Market Risk
1. The characteristic line tells us the average movement in a firm's stock price in response to a movement in the general market, such as the S&P 500 Index. The slope of the characteristic line, which has come to be called beta, is a measure of a stock's systematic or market risk. The slope of the line is merely the ratio of the "rise" of the line relative to the "run" of the line.
2. If a security's beta equals one, a 10 percent increase (decrease) in market returns will produce on average a 10 percent increase (decrease) in security returns.
3. A security having a higher beta is more volatile and thus more risky than a security having a lower beta value.