Title Unit 5.docx ✅

Unit 5 Asset Pricing • Risk and Return; Risk Premium; Mean Variance Frontier; • CAPM and its Extension; Markowitz Efficient Frontier; Arbitrage Pricing Theory Concept of Risk: As discussed in previous chapter. Simply, Risk refers to the uncertainty or variability of returns associated with an investment. It is the possibility that the actual return on an investment may differ from the expected return. Understanding and managing risk is crucial for investors, as it directly influences investment decisions, portfolio construction, and financial outcomes. Systematic Risk: Also known as market risk or non-diversifiable risk, systematic risk refers to the risk that is inherent in the overall market or economy and cannot be eliminated through diversification. It affects the entire market and is caused by factors such as macroeconomic trends, political events, changes in interest rates, natural disasters, and global economic conditions. Examples of systematic risk include recessions, inflation, wars, and changes in government policies. Since systematic risk affects all investments, it cannot be diversified away by holding a diversified portfolio. Unsystematic Risk: Unsystematic risk is the risk that is specific to an individual company, industry, or asset and can be reduced through diversification. It arises from factors that are unique to a particular investment, such as company management, product recalls, labor strikes, competition, and supply chain disruptions. By holding a well-diversified portfolio with investments across
different industries and asset classes, investors can reduce or eliminate unsystematic risk. Examples of unsystematic risk include poor earnings reports, lawsuits against a company, or a disruption in the supply chain of a specific product. Sources of Risk:  Market Risk: Risk associated with fluctuations in the overall market, such as changes in stock prices, interest rates, and currency values.  Credit Risk: Risk of default by a borrower or issuer of debt securities, such as bonds or loans.
 Liquidity Risk: Risk associated with the inability to buy or sell an asset quickly without significantly affecting its price.  Interest Rate Risk: Risk that changes in interest rates will affect the value of fixed-income securities, such as bonds.  Inflation Risk: Risk that inflation will erode the purchasing power of an investment's returns over time. Return: In financial economics, "return" refers to the gain or loss on an investment over a specific period, usually expressed as a percentage of the initial investment amount. It is a key metric used to evaluate the performance and profitability of an investment. Returns can be calculated in various ways depending on the type of investment and the desired measurement period. Total return considers not only the capital appreciation (or depreciation) of an investment but also any income generated from dividends, interest, or other distributions. It is calculated as: Total Return = Income can be in the form of Interest or Dividend income. Returns are essential for investors to assess the performance of their portfolios, make informed investment decisions, and compare the performance of different investment opportunities. However, it's crucial to consider risk alongside return, as higher returns often come with higher levels of risk.