Identify the components of a stock’s realized return.
A realized return is the amount of actual gains that is made on the value of a portfolio over a specific evaluation period. This takes into consideration any earnings generated by each of the assets contained in the portfolio, as well as any losses that were incurred as a result of a shift in the value of the individual assets. It is possible to identify the realized return associated with each asset that is held in the portfolio. Components of realized return are expected return, changes in expectations about future cash flows and changes in expectations about future discount rate. Employing the calculation of realized return ...view middle of the document...
To be compensated for risk the risk has to be special. Unsystematic risk is not, whereas, systematic is. Assets with beta larger than 1 have more systematic risk that average, will have greater expected return. Whereas, betas smaller than 1 have less systematic risk. When firms carry both types of risk, only the unsystematic risk will be eliminated by diversification when we combine man firms into a portfolio. The volatility will decline until only the systematic risk, which affects all firms remain. Since investors can eliminate unsystematic risk, they do not require a risk premium for it. However, investors cannot eliminate systematic risk they must be compensated for it. So, the risk premium of a stock depends on the amount of its systematic risk rather than its total risk.
Explain why the total risk of a portfolio is not simply equal to the weighted average of the risk of the securities in the portfolio.
The risk of a portfolio is simply a weighted average of the market related risks of individual securities plus a weighted average of the specific risks of individual securities in the portfolio. The first term constitutes the variance of the market index and the portfolio beta. The second term is the weighted average of variances of residual returns of individual securities and represents the specific risk or unsystematic risk of the portfolio. As more securities are added to the portfolio, the unsystematic risk of the portfolio becomes smaller and is negligible for a moderately sized portfolio. Thus, for a large portfolio, the residual risk or unsystematic risk is close to zero and the portfolio risk becomes equal.
State what beta measures and its uses.
Beta is a great way to measure the risk of any stock. The beta of a portfolio is a number describing the relation of its returns with the financial market. A positive beta means that the asset’s returns generally follow the market’s returns, in the sense that they both tend to be above their respective averages together, or both tend to be below their respective averages together. A negative beta means that the asset’s returns generally move opposite the market’s returns. One will tend to be above its average when the other is below its average. Beta is also referred to as a financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset’s returns to market returns. Measuring beta can give...