2. Pricing of Risk and Computation of Expected Return

c. explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk;

## d. explain return generating models (including the market model) and their uses; ## e. calculate and interpret beta;

What are the two components of Total Risk? 1. Systematic risk - risk that is inherent in the market that cannot be diversified away 2. Unsystematic risk - can be diversified away

What are the three categories of multifactor models to estimate the expected return of a security? 1. Maroeconomic factor models 2. Fundamental factor models 3. Statistical factor models

What are the factors in a macroeconomic factor model? The factors are surprises in macroeconomic variables that significantly explain equity returns.

What are the factors in a fundamental factor model? The factors are attributes of stocks or companies that are important in explaining cross-sectional differences in stock prices.

What are statistical factor models? Statistical methods are applied to a set of historical returns to determine portfolios that explain historical returns in one of two senses. - Factor analysis models: factors are the portfolios that best explain (reproduce) historical return covariances - Principal-components models: factors are portfolios that best explain (reproduce) the historical return variances.

What is Beta (β)? Beta (β) is the standardized measure of systematic risk.

What is the formula to calculate Beta? The standardized measure of systematic risk (beta) is defined as - \(\beta = \frac{Cov_{i,M}}{Cov_{M,M}} = \frac{Cov_{i,M}}{\sigma_{M^2}}\)