Risk is different with individual stocks
Fundamental: P = PV(Future Cash flows)
Current prices can only change when expectations about future cash flows change
Investors (the market) immediately update their expectations when there is news, past info does not
play any role
It is not easy to say whether (unsystematic) news is positive or negative
Same for systematic news (macroeconomic, politics, monetary policy)
Unsystematic risks disappears in large portfolios because it is by definition uncorrelated across firms
• Systematic risk stays because firm stocks co-move due to market-wide news
For individual risky securities (stocks, bonds, housing) Standard Deviation measures ‘total’ (volatility)
risk (systematic and unsystematic)
For (large) portfolios SD measures average risk → safer
We derive a model of the risk-return trade off for portfolios (Modern Portfolio Theory)
Start with portfolio with 2 assets from an investor who likes return but dislikes risk (hence, portfolios)
Average (mean) portfolio return (page 391), portfolio risk (variance) (page 396)
The lower the correlation, the more diversification (?)
Correlation is zero with unsystematic news does not affect the risk
Lower correlation implies there is more room to diversify risk
Financial globalisation/integration has increased asset correlation and thus reduced potential for
diversification
During crises, correlations dramatically increases which makes diversification ineffective when most
needed