These lectures cover risk premium on an asset, systematic risk and unsystematic risk, beta coefficient, capital asset pricing model (CAPM), securities market line, risk and return.

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This chapter has covered the essentials of risk. Along the way, we have introduced a number of definitions and concepts. The most important of these is the security market line, or SML. The SML is important because it tells us the reward offered in financial markets for bearing risk. Once we know this, we have a benchmark against which we can compare the returns expected from real asset investments to determine if they are desirable.

Because we have covered quite a bit of ground, it’s useful to summarize the basic economic logic underlying the SML as follows:

  1. Based on capital market history, there is a reward for bearing risk. This reward is the risk premium on an asset.

  2. The total risk associated with an asset has two parts: systematic risk and unsystematic risk. Unsystematic risk can be freely eliminated by diversification (this is the principle of diversification), so only systematic risk is rewarded. As a result, the risk premium on an asset is determined by its systematic risk. This is the systematic risk principle.

  3. An asset’s systematic risk, relative to the average, can be measured by its beta coefficient, βi. The risk premium on an asset is then given by its beta coefficient multiplied by the market risk premium, [E(RM) − Rf] × βi.

  4. The expected return on an asset, E(Ri), is equal to the risk-free rate, Rf, plus the risk premium:

    E(Ri) = Rf + [E(RM) − Rf] × βi

This is the equation of the SML, and it is often called the capital asset pricing model (CAPM).

This chapter completes our discussion of risk and return. Now that we have a better understanding of what determines a firm’s cost of capital for an investment, the next several chapters will examine more closely how firms raise the long-term capital needed for investment.

To calculate the portfolio variance of securities in a portfolio, multiply the squared weight of each security by the corresponding variance of the security and add two multiplied by the weighted average of the securities multiplied by the covariance between the securities.

Portfolio weight is the percentage composition of a particular holding in a portfolio. Portfolio weights can be calculated using different approaches; the most basic type of weight is determined by dividing the dollar value of a security by the total dollar value of the portfolio.

The expected market return is an important concept in risk management, because it is used to determine the market risk premium. The market risk premium, in turn, is part of the capital asset pricing model, (CAPM) formula.

The systematic risk principle states that the reward for bearing risk depends only on the systematic risk of an investment. The underlying rationale for this principle is straightforward: Because unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward for bearing it. Put another way, the market does not reward risks that are borne unnecessarily.