Aira Malinab FINMAN 1

BSBA FM 2-2

1. Understand the relationship (or “trade-off”) between risk and return.

The risk return relationship is one of the most fundamental relationships in all of finance.
The return is a measure of the amount earned by owning an asset, or an investment
over some actual holding period, or expected holding period. Return can be measured
in dollar terms, but more commonly we think of return as being a percentage return. And
the risk is a more difficult concept to conceptualize and define, but it is normally
measured by the variability in return. Again, risk is usually measured either in dollar or
percentage terms, but there are other metrics as well, some of which we will look at in
this topic. To earn more return, an asset owner must be prepared to accept more risk in
owning the asset. There is, therefore, a trade-off between risk and return.

2. Define risk and return and show how to measure them by calculating expected return,
standard deviation, and coefficient of variation.

The return is a measure of the amount earned by owning an asset, or an investment

over some actual holding period, or expected holding period. And the risk is a more
difficult concept to conceptualize and define, but it is normally measured by the
variability in return.
Calculating Risk and Return by:
 Expected return (ER) is the return that is expected to be made in the future by
holding an asset. ER is not an actual realized return like HPR, but a return we
think we will make in the future (it is forward looking).

Formula:
 Standard deviation is the most common way of measuring risk because this
measure captures the uncertainty associated with the expected return on an
asset.

Formula:
 A coefficient of variation (CV) is a statistical measure of the relative dispersion
(risk) and a measure of risk “per unit of expected return.”

Formula:

3. Discuss the different types of investor attitudes toward risk.

 Certainty equivalent (CE) is the amount of cash someone would require with
certainty at a point in time to make the individual indifferent between that certain
amount and an amount expected to be received with risk at the same point in
time.
  Risk Averse is the term applied to an investor who demands a higher expected
return, the higher the risk. Here we will take the generally accepted view that
investors are, by and large averse. This implies that risky investments must offer
higher expected returns than less risky investments in order for people to buy
and hold them.

4. Explain risk and return in a portfolio context and distinguish between individual
security and portfolio risk.

First risk on a portfolio is different from the risk on individual securities. This Risk is
reflected in the variability of the returns from zero to infinity. The expected return
depends on the probability of the returns and their weighted contribution to the risk of
the portfolio. And return of portfolio contributes in the proportion of its investment in
security. Thus, the portfolio expected return is the weighted average of the expected
returns, from each of the securities, with weights representing the proportionate share of
the security in the total investment. And portfolio risk is a measure of the uncertainty of
returns an investor can expect from an investment in a portfolio. Several types of risks
can affect a portfolio, including market risk, inflation risk, interest rate risk, liquidity
risk, and default risk.

5. Distinguish between avoidable (unsystematic)risk and unavoidable (systematic) risk;

and explain how proper diversification can eliminate one of these risks.

First the unsystematic risk is the variability of return on stocks or portfolios not explained
by general market movement. On other hand the systematic risk is the variability of
return on stocks or portfolios associated with changes in return on the market as a
whole. And diversification is one of the most effective ways to reduce unsystematic risk
because investing in various assets spreads your risk and protects your portfolio from
specific risk. Diversification does not guarantee against loss, but it can help reduce the
volatility of your portfolio and protect you from the risks of any one investment.

Systematic risk, also known as un-diversifiable risk, is the inherent risk of an investment
that cannot be diversified away. This type of risk is usually caused by factors beyond
the investor's control, such as macroeconomic factors or political conditions. 
Systematic risk affects all investments in a given market to some degree. Therefore, it
cannot be eliminated through diversification. On the other hand, unsystematic risk is
specific to a particular company or investment. This type of risk can be diversified away
through proper portfolio management. Diversification is a key element of any investment
strategy. Investors use diversification to reduce their portfolio’s overall risk by spreading
investments across several asset classes and/or geographical regions.  While
diversification cannot completely eliminate unsystematic risk, it can be reduced.
6. Define and explain the capital-asset pricing model (CAPM), beta, and the
characteristic line.

The CAPM is a model describes the relationship between risk and expected (required)
return; inn this model, a security’s expected (required) return is the risk-free rate plus a
premium based on the systematic risk of the security. And the beta (denoted as “Ba” in
the CAPM formula) is a measure of a stock’s risk (volatility of returns) to changes in
returns on the market portfolio. The beta for a portfolio is simply a weighted average of
the individual stock betas in the portfolio. A last the characteristic line is a straight line
formed using regression analysis that summarizes a particular security's systematic risk
and rate of return.

7. Calculate a required rate of return using the capital-asset pricing model (CAPM).

To calculate the required rate of return using the CAPM you have to use the formula
below:
The (capital asset pricing model) CAPM formula is represented below
Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium) Ra =
Rrf + βa * (Rm – Rrf)

8. Demonstrate how the Security Market Line (SML) can be used to describe the
relationship between expected rate of return and systematic risk.

The security market line (SML) gives the market’s expected return at different levels of
systematic or market risk. It is also called the ‘characteristic line’ where the x-axis
represents the asset’s beta or risk, and the y-axis represents the expected return. This is
also the line that describes the relationship between expected rates of return for
individual securities (and portfolios) and systematic risk, as measured by beta.

The thing that describes their relationship is this formula:

Rj = Rf + (Rm-Rf) Bj

Where:

Rj= required rate of return on a stock

Rf= risk free rate interest

Rm= the expected return for market portfolio

Bj= beta coefficient for stock

And the greater the beta, the greater the relevant risk, the greater the return required.

9. Explain what is meant by an “efficient financial market,” and describe the three levels
(or forms) to market efficiency. (GENERAL GEORGE S. PATTON)

The efficient financial market is a financial market in which current prices fully reflects all
available relevant information.

 The weak form suggests that today’s stock prices reflect all the data of past
prices and that no form of technical analysis can be effectively utilized to aid
investors in making trading decisions.
 The semi-strong form efficiency theory follows the belief that because all
information that is public is used in the calculation of a stock's  current price,
investors cannot utilize either technical or fundamental analysis to gain higher
returns in the market.
 The strong form version of the efficient market hypothesis states that all
information—both the information available to the public and any information not
publicly known—is completely accounted for in current stock prices, and there is
no type of information that can give an investor an advantage on the market.

Reflection Paper

In this and activity and lesson I have learned many things about risk and return
and how they are related to each other. And after knowing their relationship it helped
me to deepen my understanding between these two. And I also found out that there are
a lot of things, topics and methods related to these like the attitudes of investors
towards risk, how CAPM and SML different from each other, what beta is, the
unsystematic and systematic risk and how to eliminate them, and last is how to
calculate these things in the right way. Therefore, I conclude that this lesson is very
important to us, especially on the business field career that I am trying to pursue. And
these are the things that I have learned so far by doing this activity and listening to this
lesson.