Unit 7: Risk, Return, and the CAPM
This unit explains the relationship between risk and return. Every investment decision carries a certain amount of risk. Therefore, the role of the financial manager is to understand how to calculate the "riskiness" of an investment versus its reward so that they can make sound financial and business decisions. For example, suppose you are the financial manager for a large corporation, and your boss has asked you to choose between two investment proposals. Investment A is a textile plant in a remote part of a developing country. This plant can generate $50 million in yearly profits. Investment B is a textile plant located in the United States, near a small Virginia town with a rich textile industry tradition. However, investment B's capacity for profits is only $30 million due to higher start-up and operating costs. You are the financial manager. Which option do you choose? While investment A can yield significantly higher profits, there is a great deal of risk that you must consider. Investment B has a much lower profit capacity, but the risk is also lower. This unit explains the relationship between risk and return, and you will learn how to compute the level of risk by calculating expected values and the standard deviation. You will also learn about handling risk in a portfolio with different investments and how to measure a stock investment's expected performance when it is being affected by the overall performance of a stock market.
Completing this unit should take you approximately 6 hours.
Upon successful completion of this unit, you will be able to:
- explain the relationship between risk and reward;
- compute expected values when risk issues need to be considered in finance;
- differentiate between systemic and unsystemic risk;
- recommend investments that take advantage of diversification; and
- explain what the CAPM measures and its components.
7.1: Statistical Concepts in Finance
Watch this video, which gives an example of the relationship between risk and reward.
Read this section, which discusses uncertainty, expected value, fair games, and mathematical preliminaries. These form the basis for the analysis of individual decision-making in uncertain situations.
This section introduces risk and return, discusses how to understand return, and considers portfolio concerns such as diversification and weighting. It also discusses the expectations for expected returns, implications across portfolios, diversification, and understanding security lines. Risk considerations include the types of risk and measuring risk. Why are these topics of risk and return essential to consider?
7.2: Uncertainty in Capital Budgeting
Read this section and pay attention to the risks associated with capital budgeting. Why is it important to understand and apply risk in capital budgeting? Risks can include operational risks, financial risks, and market risks. The process of capital budgeting must consider the different risks faced by corporations and their managers.
7.3: Portfolio Risk, Reward, and Diversification
Read this chapter and learn more about risk and return. When and how are risk and return used in business?
Read this section that discusses portfolio diversification and weighting, implications for expected returns, and implications for variance.
This section discusses diversification and the impact of diversification on risk and return. Unsystematic risk addresses the impact of diversification on risk and return. Systematic risk evaluates the effect of diversification on risk and return. These concepts are used as corporations manage their investment portfolios and seek to achieve the best returns possible, given existing market conditions.
7.4: Risk of Stock Investments and Market Betas
This section discusses what factors affect a stock's return. How do individual company news items, and changes that affect the entire economy, impact a stock's return?
Read this section and learn more about risk and return, implications across portfolios, and the beta coefficient for portfolios. Why are these topics important to businesses? The answer is contained in this section. This section discusses how a beta coefficient compares how much a particular stock fluctuates in value daily.
Read this section that discusses expected risk and risk premium, defining the security market line, and the impact of the SML on the cost of capital.
7.5: The Capital Asset Pricing Model (CAPM)
This video will introduce you to CAPM, the model that quantifies the relationship between risk and return for stocks.
This section discusses how to price risky securities to determine if a business should undertake an investment. Why is this important? When you finish this section, you should understand unsystematic risk, systematic risk, and beta.
Unit 7 Practice and Assessment
Complete these exercises and problems and then check your work.