BUS 290 Chapter 11 - Summary Notes of Corporate Finance
Individual SecuritiesOf importance are the following characteristics of individual securities:
Estimated Return: The amount of money investors anticipate making over time. Risk and
variability: the erratic nature of a security's return Measures of the returns on two securities in
relation to one another include covariance and correlation (to another asset or index). - The
Return and Risk of Portfolios The portfolio's rate of return is based on the weighted average of
the returns on its stocks and bonds. The projected rate of return on the portfolio is calculated as a
weighted average of the anticipated returns on the portfolio's holdings. The risk of an evenly
weighted portfolio is lower than that of individual equities or bonds. Standard Deviation and
Portfolio Variance The variation of a portfolio is influenced by the variances of The covariance
between the two securities and the individual securities The variability of a security serves as a
proxy for the return variability of each individual security.
The variance of the overall portfolio is reduced when there is a negative link or covariance
between two assets. oApplies as long as there is less than perfect correlation (p1), or in other
words, when there is a negative correlation. oRisk of the entire portfolio is low if one security
increases when one decreases. oDiversification EffectSD of a portfolio composed of two
securities is less than the weighted average of the SD of the two securities - Portfolios with two
securities with various correlations The possibility for risk reduction increases with decreasing
correlation. 1.0 - Totally potential risk reduction +1.0 means there is no way to reduce risk.
Examples include the negatively linked airline and oil stocks in The Efficient Set for Two Assets.
An investor can reach any position on the curve by choosing the right combination of the two
securities. Can’t obtain points over the curve because it is impossible to raise the return on a
single security, lower its standard deviation, or lower its connection with other securities.
The Versatile Set for Many Securities The portion of the opportunity set above the minimum
variance portfolio is known as the "Efficient Frontier/Set." Every point below the efficient set
would earn a lower anticipated return and the same SD as a point on the efficient set. Invest in
bigger returns for the same amount of risk or less. Big portfolio = number of terms involving
covariance between two stocks, which is significantly higher than number of terms involving
variance of a single security. 1. Diversification Diversification can significantly reduce return
variability without correspondingly lowering anticipated returns. This decrease in risk results
from lower-than-expected returns from one asset being compensated by higher-than-expected
returns from another.
Danger that is inherent in the entire system (systematic) Minimal risk that cannot be mitigated by
diversification oNot impacted by diversification since they impact all securities in any sizable
portfolio, including interest rates, inflation, wars, etc. o Also known as portfolio risk (risk one
still bears after achieving full diversification) Unsystematic (Diversifiable) Risk: Chance
occurrences affecting a single security or small groupings of assets oWill drastically decrease
with big portfolios Total Risk is the risk associated with owning only one security. The Sensible
Investor and Risk Investors that are risk averse would rather stay away from fair bets (ones with
no expected returns) (such as the unsystematic risk on a stock) Growth in mutual fund and
exchange-traded fund investments shows that investors prefer portfolios with a variety of
investments.
Risk-free Lending and Borrowing An investor is likely to mix a risk-free asset investment with a
portfolio of risky assets. If an investor has a high aversion to risk, he will combine securities of
one with risk-free assets, and if he has a low aversion to risk, he will borrow the risk-free asset to
invest additional funds in the portfolio. The Capital Market Line (CML) is a line that is tangent
to the efficient set of risky securities - Market Equilibrium. Homogeneous Expectations: a
universe in which all investors estimate the identical anticipated returns, variances, and
covariances. o Under this idea, everyone has a market portfolio. The beta of a security is the
contribution of an individual security to the market portfolio's variation. The beta of a security is
the best indicator of its risk in a big portfolio. Beta quantifies a security's sensitivity to changes
in the market portfolio.
