FN1024 - Principles of Banking and Finance (FN1024)
Institution
University Of London
Book
Corporate Finance
Detailed summary of Chapter 8 of FN1024 - Principles of Banking and Finance, for EMFSS University of London International Programme. Based on the subject guide and extra exam material.
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FN1024 - Principles of Banking and Finance (FN1024)
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Content preview
PRINCIPLES OF BANKING
AND FINANCE
- Chapter 8: Risk and return -
Note: We suggest first studying this chapter from the Subject
Guide. Notes for ch8 are based on the guide + extra exam material.
Good luck studying!
short manual:
- includes a graph
- includes a schema/diagram
- includes an introduction
- includes additional information that
is not in the main textbook updated: 20/04/2018
, CONTENTS
CHAPTER 8: SECURITIES AND PORTFOLIOS: RISK AND RETURN
- Notes based on the Subject guide and extra exam material -
8.1. How risk affects return
8.2. Expected return and variance of security/portfolio
8.3. Mean-standard deviation (M-SD) portfolio theory
8.4. Capital asset pricing model (CAPM)
8.5. Diversification
8.6. Limitations to CAPM
8.7. Arbitrage pricing theory (APT)
, 8.1. How risk affects return
RISK AND RETURN
the relationship between the amount of risk and potential return is POSITIVE, because
investors require a compensation for bearing the risk
o a lower risk security has lower potential for return (e.g. government bonds)
o a higher risk security has higher potential for return (e.g. common stocks)
important: greater amount of risk doesn’t automatically mean greater actual return but
rather potential return on the financial asset
RISK AND RETURN SPECTRUM (from lowest return to highest return)
Treasury bills (short maturity + low default risk)
Treasury bonds (longer maturity + low default risk)
Large firm common stocks (high volatility)
Small firm common stocks (highest volatility)
RISK AND HOLDING PERIOD
the relationship between the amount of risk and the length of holding period is
NEGATIVE, because over long periods variations in return offset each other
o a lower risk security is the one held for longer period of time
o a higher risk security is the one held for shorter period fo time
RISK AND HOLDING PERIOD SPECTRUM (from shortest to longest)
Treasury bills (shorter holding period, higher risk)
Small firm common stocks (shorter holding period, higher risk)
Treasury bonds (longer holding period, lower risk)
Large firm common stocks (longer holding period, lower risk)
HOW RISK AFFECTS VALUE OF ASSET IN EQUILIBRIUM?
risk increases potential return that means greater DISCOUNT RATE
greater discount rate lower PRICE (value of asset in equilibrium)
-2-
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