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Risk and Return - Coggle Diagram
Risk and Return
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Evaluating Risk
In the end investors must relate the risk perceived in a given security not only to return but also their own attitudes towards risk.
The individual investor typically tends to want to know whether the perceived risk is worth taking in order to get the expected return and whether a higher return is possible for the same level of risk.
In the decision process, investors evaluate the risk-return behavior of each alternative investment to ensure that the return expected is “reasonable” given its level of risk.
If other vehicles with lower levels of risk provide greater returns, the investment would not be deemed acceptable.
An investor would select the opportunities that offer the highest returns associated with the level of risk they are willing to take.
Risk and Return
Security analysis is built around the idea that investors are concerned with two characteristics inherent in securities
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Interest Rate Risk
Refers to uncertainty of future market values and the size of future income, caused by fluctuations in the level of interest rates.
Interest rate risk – interest paid on government securities may rise or fall and hence the rate of return demanded on alternative investment such as stocks and bonds issued in the private sector may also rise or fall.
Business Risk
Internal Business Risk
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Associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it.
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Efficient Portfolio
A portfolio is efficient when it is expected to yield the highest return for the level of risk accepted or the smallest portfolio risk for a specified level of expected return.
To build an efficient portfolio, an expected return level is chosen, and assets are substituted until the portfolio combination with the smallest variance at the return level is found.
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Risk
Risk in holding securities is generally associated with the possibility that realized returns will be less than the return that was expected.
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Systematic Risk
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Refers to that portion of total variability in return caused by factors affecting the prices of all securities.
Economic, political and sociological changes are sources of systematic risk. Also, market risk
Market Risk
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The basis for the reaction are real events like depression, war or politics.
Intangible events are related to market psychology. The initial decline in the market can cause fear and encourage investors to make for the exit.
Purchasing Power Risk
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Rising prices on goods and services are associated with inflation, and falling prices of goods and services are termed deflation.
Rational investors should include in their estimate of expected return an allowance for purchasing power risk.
Unsystematic Risk
Also known as diversified or controllable risk. It is the portion of total risk that is unique to a firm or industry.
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Factors such as management capability, consumer preferences, labor strikes cause variability of returns in a firm.
Unsystematic factors are largely independent of factors affecting securities markets in general. Because these factors affect one firm, they must be examined for each firm.
Financial Risk
Associated with the way a company finances its activities i.e. based on the capital structure of the firm.
The presence of debt creates fixed payment in the form of interest that must be sustained by the firm.
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Security Analysis
Security analysis cannot be predicted with certainty i.e. a stock price will increase/ decrease by exactly how much.
Analysts cannot understand political and socioeconomic forces completely enough to permit predictions that are beyond doubt or error.
Analysts must strive to provide careful and reasonable estimates of return and some measure of the degree of uncertainty associated with these estimates.
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Measuring Systematic Risk, Beta (𝛽)
A statistical measure of risk which the amount of systematic risk present in a particular risky asset relate to that in an average risky asset.
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Studies have shown that by carefully selecting as few as 15 securities for a portfolio, diversifiable risk can almost be entirely eliminated.
Asset with larger betas have greater systematic risk, eventually they will have greater expected return.
Non-diversifiable risk is unavoidable and each security possesses its own level of non-diversifiable risk, measured using the beta coefficient.
Assumptions of CAPM
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Investors have homogenous expectations – they have identical, subjective estimate of the means, variances among returns.
Security Market Line
When CAPM is depicted graphically, it is called Security Market Line (SML).
Plotting CAPM, we would find SML to be a straight line.
SML tells us the required return an investor should earn in the marketplace for any level of systematic (𝛽) risk.
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A line used in the CAPM that plots the rates of return for efficient portfolios, depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.
Capital Market Line
The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.
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