Return, Risk and the Security Market Line

 Expected and Unexpected Returns

= The return on any stock traded in a financial market is composed of two parts:

1. Normal (or Expected) return from the stock is the part of the return that investors predict or expect. This return
depends on the information investors have about the stock, and it is based on the market’s understanding today of the
important factors that will influence the stock in the coming year.
2. Risky (or Unexpected) return from the stock is the part that comes to uncertain/unexpected information revealed
during the year.

= One way to express the return is:

Total return – Expected return = Unexpected return
Or
R - E(R) = U

 Announcement and News

= An announcement can be broken into two part, the expected (E(R)) part plus the unexpected or surprise (U):
Announcement = Expected part + Surprise
or
R = E(R) + U

 Systematic and Unsystematic Risk

= If we always receive exactly what we expect, then the investment is perfectly predictable and, by definition,
risk-free. In other words, the risk of owning an asset comes from surprises—unanticipated events.

1. Systematic Risk = Risks that influence a large number of assets. Also called market risk.
= GDP, interest rates, or inflation. These conditions affect nearly all companies to some degree.
2. Unsystematic Risk = Risks that influences a single company or a small group of companies. Also called unique or
asset-specific risk.
= Unsystematic event, for example, is the announcement of an oil strike by a particular company.
It will primarily affect that company and, perhaps, a few others (such as primary competitors and suppliers). It is
unlikely to have much effect on the world oil market, however, or on the affairs of companies not in the oil business.

 Systematic and Unsystematic Components of Return

= The distinction between a systematic risk and an unsystematic risk is never really as exact as we would like
it to be. Even the most narrow and peculiar bit of news about a company ripples through the economy. This
ripple effect happens because every enterprise, no matter how tiny, is a part of the economy. However, not all
ripple effects are equal—some risks have a much broader effect than others.

= The distinction between the two types of risk allows us to break down the surprise portion, U, of the return
on the Flyers stock into two parts.
R – E(R) = Systematic portion + Unsystematic portion
or
R - E(R) = U = m + E

 Systematic Risk Principle

= Systematic Risk Principle – The reward for bearing risk depends only on the systematic risk of an
investment.
= The expected return on assets depends only on its systematic risk.

 Measuring Systematic Risk

= Beta Coefficient (B) – Measure of the relative systematic risk of an asset. Assets with betas larger (smaller)
than 1 have more (less) systematic risk than average.
= By definition, an average asset has a beta of 1.0 relative to itself. An asset with a beta of .50, therefore, has
half as much systematic risk as an average asset. Likewise, an asset with a beta of 2.0 has twice as much systematic
risk.
 Portfolio Beta
 = The calculation
The first step is to multiply the percentage of your portfolio and the beta for each individual stock. Once
that is done, simply add up the results and you'll have your portfolio beta.