Finance: Risk Assessment, Expected Return, and Portfolio Management

Risk Assessment

• Risk assessment involves identifying, analyzing, and measuring the uncertainty of investment outcomes.
• Types of risk:
  • Systematic risk (market risk): cannot be diversified away
  • Unsystematic risk (idiosyncratic risk): can be diversified away
• Risk measurement metrics:
  • Standard deviation (σ)
  • Variance (σ²)
  • Beta (β)
  • Value-at-Risk (VaR)

Expected Return

• Expected return is the expected value of an investment's return
• Calculated as the weighted average of possible returns
• Factors affecting expected return:
  • Risk-free rate (Rf)
  • Market return (Rm)
  • Beta (β)
  • Expected excess return (α)

Diversification

• Diversification reduces portfolio risk by combining assets with low correlation
• Diversification benefits:
  • Reduces portfolio risk
  • Increases potential returns
  • Improves portfolio efficiency
• Diversification strategies:
  • Naive diversification: equal weighting of assets
  • Markowitz diversification: optimization of portfolio weights

Portfolio Management

• Portfolio management involves creating and managing a portfolio of assets to achieve investment objectives
• Portfolio management process:
  1. Portfolio construction: selecting and weighting assets
  2. Portfolio monitoring: tracking portfolio performance
  3. Portfolio rebalancing: adjusting portfolio weights
• Portfolio management strategies:
  • Active management: actively trading assets to beat the market
  • Passive management: tracking a market index

Asset Pricing

• Asset pricing models describe the relationship between risk and expected return
• Asset pricing models:
  • Capital Asset Pricing Model (CAPM): expected return = Rf + β(Rm - Rf)
  • Arbitrage Pricing Theory (APT): expected return = Rf + β1(Rm - Rf) + β2(Rm - Rf) + ...
  • Factor models: expected return = Rf + β1(Factor 1) + β2(Factor 2) + ...
• Asset pricing implications:
  • Higher risk requires higher expected return
  • Diversification can reduce risk and increase expected return