INvestors require greater returns for taking greater risk.
They prefer the investment with the highest possible return for a given level of risk or the investment with the lowest risk for a given level of return.
Explain what an expected return is
The expected return is a weighted average of the possible returns from an investment, where each of these returns is weighted by the probability that it will occur
Explain what standard deviation of returns is, explain why it is especially useful in finance
SD of returns is a measure of the total risk associated with the returns from an asset.
Tells us about the probability that a return will fall within a particular distance from the expected value or within a particular range.
Square root of variance
Explain the concept of diversification
Diversification is a strategy of investing in two or more assets whose values do not always move in the same direction at the same time in order to reduce risk.
Reduces risk because some of the changes in the prices of individual assets offset each other.
This can cause the overall volatility in the value if the portfolio to be lower than if it were invested in a single asset.
Discuss which type of risk matters to investors and why
Investors care about only systematic risk.
This is because unique risk can be eliminated through a diversified portfolio.
Diversified investors will bid up prices for the assets to the point at which they are just being compensated for the systematic risks they must bear.
Describe what the CAPM tells us and how to use it to evaluate whether the expected return of an asset is sufficient to compensate an investor for the risks associated with that asset
CAPM: capital asset pricing model
CAPM tells us that the relationship between systematic risk and return is linear and that the risk free rate of return is appropriate return for an asset with no systematic risk.
If the expected return is lwoer than that calculated by CAPM, then the asset is an unattratice investment because its return is lwoer than the CAPM indicates it should be.