Every financial transaction has an element of risk to it, meaning an investor can make money or lose money on the transaction. The gain an investor makes on a transaction is called reward or return. Risk is the uncertainty of future cash flows. There are many types of risk, such as liquidity risk, operational risk, market risk, price risk, credit risk, counterparty risk, maturity risk, default risk, geopolitical risk and many more. For every risk, there is an accompanying risk premium. The types of risk are derived from the understanding that there is one or more element existing or event occurring that could jeopardize the cash flows expected from a transaction. In finance, the common saying is "The greater the risk, the greater the expected reward". Return is the reward one gets for bearing risk. The riskier a transaction, the greater payout one should expect. Sometimes investors want to maximize the return portion of an investment portfolio, while minimizing the risk, and to achieve that there are primarily three options for risk mitigation: diversification, hedging, and purchasing insurance of some type. Purchasing insurance on a financial position or investment is pretty straightforward to understand. Hedging requires the investors to take an opposite and offsetting position.
Since there is a chance that an investor may not profit on a transaction, investors can compute an expected return. Expected return is the total return anticipated after taking into consideration both the expected payout and the likelihood of that payout occurring. To compute the expected value of one investment, multiply the investment's expected payout (profit or loss) times the probability that that payout will occur. This technique can be used to compare the expected value of investments so that one can determine how to best allocate funds, or it can be done for a group of investments (known as a portfolio) in which the investor is simultaneously invested to determine total expected return of all investment's held.
Numerically, risk is quantified in finance with a measure called the standard deviation. The standard deviation is a measure that is commonly associated with predicting expected stock returns or portfolio returns, using historical returns of a stock. The expected returns are an average of the stock's returns. The standard deviation, which is also the square root of the variance, is a measure of how volatile a stock's returns are compared to its average returns. Therefore, when investing in a financial transaction, one has an expected return that he or she estimates will be earned on a transaction if they hold the investment to maturity and if no additional risk occurs beyond what historically has occurred. Multiplying that expected return by its volatility and then by its percentage weight in the portfolio and summing all of those for each stock in a portfolio gives the expected return of the entire portfolio and is the basis of portfolio theory in finance.
The computation of expected value is an important financial analysis undertaken by financial managers. Expected values can be computed for many different risk scenarios, across which both the payout scenario and the probability of the payout can vary. The general practice is that financial managers invest in the portfolio of investments that yields the highest expected value. But again, to benefit from the highest expected value, the financial manager has had to accept the highest level of risk, which is not always optimal. Investors have different risk tolerances, meaning some feel more comfortable with higher risk levels, while others prefer to assume a lower level of risk and the resulting lower expected value. To reflect the varying risk preferences of investors, it is said that investors exist on a spectrum of risk averseness, which describes highly risk averse (investors who do not want to tolerate any risk) to those with low risk aversions (investors who can tolerate great amounts of risk).
The expected return of a stock is uncertain, there are many factors affecting stock performance and whether it ultimately generates a return. There is always a probability that the stock's performance will deviate from its historical average (expected) return, the return of a stock is also impacted by the overall performance of the stock market and an individual stock's relative behavior to the market's behavior. The measure of how a stock performs in relation to the market itself is called "beta", which is another measure of risk – systematic risk. Systematic risk is also called non-diversifiable risk or market risk. Systematic risk does not go away and is always present. Unsystematic risk is the opposite of systematic risk. It is the risk that individual securities have that can be gotten rid of; investors say that it can be "diversified away". Therefore unsystematic risk is also called diversifiable risk, asset-unique risk, or company-specific risk.
A stock can perform better than the market, the same as the market, or worse than the market depending on the value of beta. The beta of a stock is calculated using a statistical technique called regression. For the purposes of introductory finance, you will not have to use regression analysis to compute betas, but rather they will be provided for you or you will be able to solve for the beta easily by using the information in the problem.
There is more than one calculation to compute expected return. One foundational methodology developed specifically for stock returns is the Capital Asset Pricing Model, known as CAPM. The basic components of CAPM are: the risk-free rate on a riskless asset in the US economy, the expected return of the stock market, and the beta of the risky asset. The CAPM allows for the computation of the expected return of a risky security, taking into consideration the stock's beta and the market risk premium, which is the expected return of the entire market minus the risk-free rate. The risk-free rate is the interest rate on a security in the economy that is believed to hold very little risk for investors, which is customarily the rate on the 1-month or 3-month US Treasury Bill. The rate on that security is considered to represent the least amount of risk to investors because the life of the security is so short and because the US government, having the highest credit rating, is almost certain not to default on its obligations.
To analyze an investment portfolio, you need to know the amount of money invested in each asset and the weight of that investment to the entire portfolio, which means the percentage of the entire portfolio amount invested in each security. You also need to know the expected return for each asset. You first need to compute the expected return for each asset, if that information is not already provided. You compute the expected return using the CAPM formula and the asset's beta. Once you have the outcome of CAPM for each security in the portfolio, you can find the expected value of the entire portfolio. The expected value of a portfolio is the sum for all assets in the portfolio, the following computation for each asset: the asset's investment amount multiplied by that asset's expected return multiplied by that asset's portfolio. The product of multiplying those three elements for each is asset is then summed together with products obtained from computing the same for each asset in the portfolio. The result is the expected return of the portfolio.
This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.
Try to think of the reason why each term is included.