Assignment

Risk and Return
5.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Risk and Return

Defining Risk and Return Using Probability Distributions to Measure Risk Attitudes Toward Risk Risk and Return in a Portfolio Context Diversification
5.2
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Defining Return
Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment.
R=
5.3
Dt + (Pt Pt - 1 )
Pt - 1
Return Example
The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year?
5.4
Return Example
The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year?
$1.00 + ($9.50 $10.00 ) = 5% R= $10.00

Required Rate of Return

Its
the minimum level of return desired from any particular investment alternative. rate of return, expected inflation and risk is considered during its calculation.
Real
5.6
Expected Rate of Return

Return
based on the expected cash receipts over the holding period and the expected ending or selling price. rate
the rate is guaranteed, most investors recognize the several rates of returns as possible
Ex-ante
Unless
5.7
Defining Risk
The variability of returns from those that are expected.
What rate of return do you expect on your investment (savings) this year? What rate will you actually earn? Does it matter if it is a bank CD or a share of stock?
Sources of Investment Risk

Business Risk Financial Risk Liquidity Risk
Default

5.9
Risk
Interest Rate Risk Management Risk Purchasing Power Risk

Determining Expected Return (Discrete Dist.)

R = S ( Ri )( Pi )
I=1 n
R is the expected return for the asset,
Ri is the return for the ith possibility,

Pi is the probability of that return occurring, n is the total number of possibilities.
How to Determine the Expected Return and Standard Deviation

Stock BW Ri Pi
-0.15 -0.03 0.09 0.21 0.33 Sum
5.11
(Ri)(Pi)
0.015 0.006 0.036 0.042 0.033 0.090
0.10 0.20 0.40 0.20 0.10 1.00
The expected return, R, for Stock BW is .09 or 9%
Determining Standard Deviation (Risk Measure)

s=
i=1
S ( Ri R )2( Pi )
Standard Deviation, s, is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. Note, this is for a discrete distribution.
How to Determine the Expected Return and Standard Deviation

Stock BW Ri Pi 0.15 0.10 0.03 0.20 0.09 0.40 0.21 0.20 0.33 0.10 Sum 1.00
5.13
(Ri)(Pi) 0.015 0.006 0.036 0.042 0.033 0.090
(Ri - R )2(Pi) 0.00576 0.00288 0.00000 0.00288 0.00576 0.01728
Determining Standard Deviation (Risk Measure)

s=
S ( Ri R )2( Pi ) i=1
s=
.01728
s = 0.1315 or 13.15%
Coefficient of Variation
The ratio of the standard deviation of a distribution to the mean of that distribution. It is a measure of RELATIVE risk.
CV = s/R CV of BW = 0.1315 / 0.09 = 1.46

Discrete versus. Continuous Distributions

Discrete
0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0.15 0.03 9% 21% 33%
Continuous
0.035 0.03 0.025 0.02 0.015 0.01 0.005 0
13% 22% 31% 40% 49% 58% -50% -41% -32% -23% -14% 67% -5% 4%
5.16
Risk Attitudes
Certainty Equivalent (CE) is the amount of cash someone would require with certainty at a point in time to make the individual indifferent between that certain amount and an amount expected to be received with risk at the same point in time.
5.18
Risk Aversion
Risk Neutral
Investors Seek the Highest Return Without Regard to Risk
Risk Seeking
Investors Have a Taste for Risk and Will Take Risk Even If They Cannot Expect a Reward for Doing So
Risk Averse
Investors Do Not Like Risk and Must Be Compensated For Taking It
Historical Returns on Financial Assets Are Consistent with a Population of Risk-Averse Investors
5.19
Risk Attitude Example

You have the choice between (1) a guaranteed dollar reward or (2) a coin-flip gamble of $100,000 (50% chance) or $0 (50% chance). The expected value of the gamble is $50,000.
Mary requires a guaranteed $25,000, or more, to call off the gamble.

Raleigh is just as happy to take $50,000 or take the risky gamble. Shannon requires at least $52,000 to call off the gamble.
5.20
Risk Attitude Example

What are the Risk Attitude tendencies of each?
Mary shows risk aversion because her certainty equivalent < the expected value of the gamble. Raleigh exhibits risk indifference because her certainty equivalent equals the expected value of the gamble.
Shannon reveals a risk preference because her certainty equivalent > the expected value of the gamble.
Determining Portfolio Expected Return

RP = S ( Wj )( Rj )
J=1
m
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for the jth asset in the portfolio,
Rj is the expected return of the jth asset, m is the total number of assets in the portfolio.
Determining Portfolio Standard Deviation

sP =
S S Wj Wk s jk J=1
K=1
Wj is the weight (investment proportion) for the jth asset in the portfolio, Wk is the weight (investment proportion) for the kth asset in the portfolio,
sjk is the covariance between returns for

the jth and kth assets in the portfolio.
What is Covariance?
s jk = s j s k r jk
sj is the standard deviation of the jth

asset in the portfolio,
sk is the standard deviation of the kth

asset in the portfolio, rjk is the correlation coefficient between the jth and kth assets in the portfolio.
Correlation Coefficient
A standardized statistical measure of the linear relationship between two variables.
Its range is from 1.0 (perfect negative correlation), through 0 (no correlation), to +1.0 (perfect positive correlation).
Diversification and the Correlation Coefficient

INVESTMENT RETURN SECURITY E SECURITY F Combination E and F
TIME
TIME
TIME
Combining securities that are not perfectly, positively correlated reduces risk.
Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.

STD DEV OF PORTFOLIO RETURN
Factors such as changes in the nations economy, tax reform by the Congress, or a change in the world situation.
Unsystematic risk Total Risk Systematic risk
NUMBER OF SECURITIES IN THE PORTFOLIO


STD DEV OF PORTFOLIO RETURN
Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract.
Unsystematic risk Total Risk Systematic risk
NUMBER OF SECURITIES IN THE PORTFOLIO

What is Beta?
An index of systematic risk.
It measures the sensitivity of a stocks returns to changes in returns on the market portfolio. The beta for a portfolio is simply a weighted average of the individual stock betas in the portfolio.
Characteristic Lines and Different Betas

EXCESS RETURN ON STOCK
Beta > 1 (aggressive)
Beta = 1
Each characteristic line has a different slope. Beta < 1 (defensive)
EXCESS RETURN ON MARKET PORTFOLIO
5.31
Security Market Line

Rj = Rf + bj(RM Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,

bj is the beta of stock j (measures systematic risk of stock j), RM is the expected return for the market portfolio.
Security Market Line

Rj = Rf + bj(RM Rf)
Required Return RM Rf
bM = 1.0
Risk Premium
Risk-free Return
Systematic Risk (Beta)
Determination of the Required Rate of Return

Lisa Miller at Basket Wonders is attempting to determine the rate of return required by their stock investors. Lisa is using a 6% Rf and a long-term market expected rate of return of 10%. A stock analyst following the firm has calculated that the firm beta is 1.2. What is the required rate of return on the stock of Basket Wonders?
BWs Required Rate of Return

RBW = Rf + bj(RM Rf) RBW = 6% + 1.2(10% 6%)
RBW = 10.8%
The required rate of return exceeds the market rate of return as BWs beta exceeds the market beta (1.0).

Much more than documents.

Assignment

Uploaded by

Document Information

Description:

Copyright:

Available Formats

Assignment

Uploaded by

Description:

Copyright:

Available Formats

Related titles

Risk and Return

Risk and Return

$1.00 + ($9.50 $10.00 ) = 5% R= $10.00

Required Rate of Return

Expected Rate of Return

Sources of Investment Risk

Business Risk Financial Risk Liquidity Risk

Interest Rate Risk Management Risk Purchasing Power Risk

Determining Expected Return (Discrete Dist.)

R is the expected return for the asset,

Ri is the return for the ith possibility,

How to Determine the Expected Return and Standard Deviation

0.10 0.20 0.40 0.20 0.10 1.00

The expected return, R, for Stock BW is .09 or 9%

Determining Standard Deviation (Risk Measure)

How to Determine the Expected Return and Standard Deviation

(Ri)(Pi) 0.015 0.006 0.036 0.042 0.033 0.090

(Ri - R )2(Pi) 0.00576 0.00288 0.00000 0.00288 0.00576 0.01728

Determining Standard Deviation (Risk Measure)

CV = s/R CV of BW = 0.1315 / 0.09 = 1.46

Discrete versus. Continuous Distributions

Investors Do Not Like Risk and Must Be Compensated For Taking It

Risk Attitude Example

Mary requires a guaranteed $25,000, or more, to call off the gamble.

Risk Attitude Example

Determining Portfolio Expected Return

RP is the expected return for the portfolio,

Determining Portfolio Standard Deviation

sjk is the covariance between returns for

sj is the standard deviation of the jth

sk is the standard deviation of the kth

Diversification and the Correlation Coefficient

Total Risk = Systematic Risk + Unsystematic Risk

Total Risk = Systematic Risk + Unsystematic Risk

Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Total Risk = Systematic Risk + Unsystematic Risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Characteristic Lines and Different Betas

Beta > 1 (aggressive)

EXCESS RETURN ON MARKET PORTFOLIO

Security Market Line

Rf is the risk-free rate of return,

Security Market Line

Determination of the Required Rate of Return

BWs Required Rate of Return

Related Interests

Documents Similar To Assignment

More From arjun_niroula

Popular in Beta (Finance)