Diversification and CAPM

?
  • Created by: sian.s
  • Created on: 22-02-20 08:36
What is the concept of diversification
By investing in 2 or more assets whose values do not always move in the same direction at the same time an investor can reduce the risk of his collection of investment (portfolio)
1 of 30
When comparing one investment wiht anohter what is it necessary to do
use a measure of relative variability to indicate risk per unit of expected return.
2 of 30
Why use a measure of relative variabilty when comparing two investment risk and return
• Because you want to have the highest expected return given the same level of risk (or the lowest risk given the same level of expected return)This is the optimal risk-return trade-off
3 of 30
What is the tool for comparing risk and return for individual stocks
coefficient of variation (CV):
4 of 30
What is CVi
is a measure of the risk associated with an investment for each 1% of expected return
5 of 30
What can coefficient of variation not account for
critical shortcoming when applied to a portfolio of assets: they cannot account for the diversification of different assets’ risks when they are grouped into a portfolio
6 of 30
Because coefficient of variation does not account for diverisifcation what do you use
expected return for a portfolio composed by more than one assets (weight x expected return) +(weight x expected return) +(weight x expected return) ……
7 of 30
What does diverisifcation do
The risk for a portfolio composed by two individual stocks could be less than the average of the risks associated with the individual stocks because of the benefit of diversification
8 of 30
Why does diversification work
• When stock prices move toward opposite directions at the same time, the price change of one stock offsets some of the price change of another stock
9 of 30
What does covariance indicate
• Covariance indicates whether stocks’ returns tend to move in the same direction at the same time. If YES, the covariance is positive. • If NO, it is negative for opposite direction or zero for the case when one moves and the other keeping still.
10 of 30
what is the risk of a portfolio determined by
• Whether the risk for a portfolio of two different stocks could be less than the average of the risks associated with the individual stocks is determined by the strength of the covariance relationship
11 of 30
What is covariance
Covariance is a measure of how the returns on two assets co-vary or move together
12 of 30
to measure the strength of a covariance relationship what do you do
divide the covariance by the product of the standard deviations of the assets’ returns. This result is called the correlation coefficient that measures the strength of the relationship between the assets’ returns
13 of 30
Why id correlation coffeficient different to covariance
The use of correlation coefficient serves the same goal as covariance but it is a better measurement since it has been normalized.
14 of 30
What is negative positive and zero correlation
Negative correlation indicates that the returns on two move in opposite directions
15 of 30
What is positive correlation
Positive correlation indicates that the returns on two move in the same direction
16 of 30
What is zero correlation
Zero correlation indicates there is no linear relationship between returns on the assets
17 of 30
what correlation do you want
To enjoy the benefit of diversification in risk reduction, you want to have an asset portfolio composed by assets which have stronger negative correlation coefficient between their returns
18 of 30
what are the limits of diversification benefits
When the number of assets in a portfolio is large, adding another stock has almost no effect on the standard deviation, Most risk-reduction from diversification may be achieved with 15-20 assets, Diversification can not eliminate market risk
19 of 30
What did Markowitz say
more investor diversifies the greater the risk reduction effect
20 of 30
what is the risk of individual assets with diversification
composed by two components: firm-specific risk + systematic risk
21 of 30
what is specific risk
• Firm-specific risk relevant for a particular firm can be diversified away and is called diversifiable, unsystematic, or unique risk
22 of 30
what is systematic risk
• Risk that cannot be diversified away is non-diversifiable, or systematic risk. This is the risk inherent in the market or overall economy
23 of 30
why does systematic risk occur
• Systematic risk is due to changes in general economic conditions, such as the business cycle, the inflation rate, interest rates, exchange rates, and so forth. Such risk factors are common to whole economy and can’t be diversified away.
24 of 30
what doe well diversified portfolios only contain
• Well-diversified portfolios contain only systematic risk • Portfolios that are not well-diversified face systematic risk plus unsystematic risk (i.e. firm-specific risk)
25 of 30
what is the investors compensation for systematic risk
This is the risk premium required by investor to undertake the systematic risk The difference between the required rate of return on a risky asset R_i and the return on a risk-free asset R_rf is an investor’s compensation for systematic risk
26 of 30
what model described the relationship between risk and required return for an asset
The Capital Asset Pricing Model (CAPM) describes the relationship between risk and required return for an asset
27 of 30
what is beta
The systematic risk component contained in the asset contributing to the variance of it’s return is therefore quantified in beta
28 of 30
what are beta vals
• Zero =asset has no measurable systematic risk • 1 < B = assets systematic risk is greater than the average for all assets in the market •1 > B = asset systematic risk is less than the average for all assets in the market
29 of 30
what is the required risk premium intuion behind CAPM
Since systematic risk can’t be diversified away via diversification, therefore, such risk can be compensated. e required risk premium is for the systematic risk contained in the investment
30 of 30

Other cards in this set

Card 2

Front

When comparing one investment wiht anohter what is it necessary to do

Back

use a measure of relative variability to indicate risk per unit of expected return.

Card 3

Front

Why use a measure of relative variabilty when comparing two investment risk and return

Back

Preview of the front of card 3

Card 4

Front

What is the tool for comparing risk and return for individual stocks

Back

Preview of the front of card 4

Card 5

Front

What is CVi

Back

Preview of the front of card 5
View more cards

Comments

No comments have yet been made

Similar Business Studies resources:

See all Business Studies resources »See all Finance resources »