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Learning Objectives
1. Define and measure the expected rate of return of an
individual investment.
2. Define and measure the riskiness of an individual investment.
3. Compare the historical relationship between risk and rates of
return in the capital markets.
4. Explain how diversifying investments affects the riskiness and
expected rate of return of a portfolio or combination of
assets.
5. Explain the relationship between an investorƞs required rate of
return on an investment and the riskiness of the investment.
1. åhat is risk?
Ö Examples of portfolio:
Ö ßportfolio= · wj*ßj
w
k=kfr + krp
åhere:
Ö k=kfr + krp
Or
krp = k - kfr
Keown, Martin, Petty - Chapter 6 34
Capital Asset Pricing Model
Ö CAPM equates the expected rate of return on
a stock to the risk-free rate plus a risk
premium for the systematic risk.
Example:
Market risk = 12%
Risk-free rate = 5%
5% + B(12% - 5%)
If B = 0, Required rate = 5%
If B = 1, Required rate = 12%
If B = 2, Required rate = 19%
Keown, Martin, Petty - Chapter 6 38
The Security Market Line
(SML)