tooneorafewinvestmentsandriskthataffectsamuchwider
crosssectionofinvestments.Wearguethatinamarketwhere
themarginalinvestoriswelldiversified,itisonlythelatter
risk,calledmarketrisk,thatwillberewarded.Third,wewill
lookatalternativemodelsformeasuringthismarketriskand
the expected returns that go with it.
Step 1: Measuring Risk
Investorswhobuyassetsexpecttoearnreturnsoverthetime
horizonthattheyholdtheasset.Theiractualreturnsoverthis
holding period may be very different from the expected
returns,anditisthisdifferencebetweenactualandexpected
returnsthatgivesrisetorisk.Forexample,assumethatyou
are an investor with a one-year time horizon buying a
one-year Treasury bill (or any other default-free one-year
bond) witha 5 percent expectedreturn.Atthe endof the
one-yearholdingperiod,theactualreturnonthisinvestment
willbe 5 percent,whichisequaltotheexpectedreturn.This
isarisklessinvestment.Toprovideacontrasttotheriskless
investment,consideraninvestorwhobuysstockinGoogle.
Thisinvestor,havingdoneherresearch,mayconclude that
shecanmake anexpectedreturnof 30 percent onGoogle
overherone-yearholdingperiod.Theactualreturnoverthis
periodwillalmostcertainlynotbeequalto 30 percent;itwill
bemuchgreaterormuchlower.Notethattheactualreturns,
inthiscase,aredifferentfromtheexpectedreturn.Thespread
oftheactualreturnsaroundtheexpectedreturnismeasured
bythevarianceorstandarddeviationofthedistribution;the
greater the deviation of the actual returns from expected
returns, the greater the variance.