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Risk and Return

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Risk and Return  Defining Risk and Return  Using Probability Distributions to Measure Risk  Attitudes Toward Risk  Risk and Return in a Portfolio Context 5-2 .

usually expressed as a percent of the beginning market price of the investment.Pt-1 ) Pt-1 .Defining Return Income received on an investment plus any change in market price. R= 5-3 Dt + (Pt .

The stock is currently trading at $9. 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.50 per share and shareholders just received a $1 dividend.

Return Example The stock price for Stock A was $10 per share 1 year ago.00 ) = 5% R= $10.50 .00 5-5 . What return was earned over the past year? $1.00 + ($9.50 per share and shareholders just received a $1 dividend.$10. The stock is currently trading at $9.

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? 5-6 .

Determining Expected Return (Discrete Dist. 5-7 . n is the total number of possibilities.) 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.

33 Sum 5-8 (Ri)(Pi) -.10 1.20 .042 .03 .40 .006 .015 -.21 .036 .10 .00 The expected return.09 . R.090 .How to Determine the Expected Return and Standard Deviation Stock BW Ri Pi -.09 or 9% .15 -.20 .033 . for Stock BW is .

It is the square root of variance. s.Determining Standard Deviation (Risk Measure) s= i=1 S ( Ri . this is for a discrete distribution. 5-9 . is a statistical measure of the variability of a distribution around its mean. Note.R )2( Pi ) n Standard Deviation.

20 .10 -.R )2(Pi) .00000 .15 .09 .01728 .21 .00288 .00 5-10 (Ri)(Pi) -.033 .006 .015 -.33 .090 (Ri .20 .00576 .How to Determine the Expected Return and Standard Deviation Stock BW Ri Pi -.042 .00576 .036 .10 Sum 1.40 .03 .00288 .

1315 or 13.R )2( Pi ) i=1 s= n .Determining Standard Deviation (Risk Measure) s= S ( Ri .15% .01728 s= 5-11 .

It is a measure of RELATIVE risk.46 5-12 . CV = s / R CV of BW = .1315 / .Coefficient of Variation The ratio of the standard deviation of a distribution to the mean of that distribution.09 = 1.

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. 5-13 .

Risk Attitudes Certainty equivalent > Expected value Risk Preference Certainty equivalent = Expected value Risk Indifference Certainty equivalent < Expected value Risk Aversion 5-14 Most individuals are Risk Averse. .

to call off the gamble. is just as happy to take $50.000 to call off the gamble. or more.  Raleigh  Shannon 5-15 . requires at least $52. The expected value of the gamble is $50.000 or take the risky gamble.000.  Mary requires a guaranteed $25.Risk Attitude Example You have the choice between (1) a guaranteed dollar reward or (2) a coin-flip gamble of $100.000.000 (50% chance) or $0 (50% chance).

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. Shannon reveals a “risk preference” because her “certainty equivalent” > the expected value of the gamble. 5-16 . Raleigh exhibits “risk indifference” because her “certainty equivalent” equals the expected value of the gamble.

Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. 5-17 .Total Risk = Systematic Risk + Unsystematic 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. It is avoidable through diversification.

Unsystematic risk Total Risk Systematic risk NUMBER OF SECURITIES IN THE PORTFOLIO 5-18 . or a change in the world situation.Total Risk = Systematic Risk + Unsystematic Risk STD DEV OF PORTFOLIO RETURN Factors such as changes in nation’s economy. tax reform by the Congress.

Unsystematic risk Total Risk Systematic risk NUMBER OF SECURITIES IN THE PORTFOLIO 5-19 .Total Risk = Systematic Risk + Unsystematic Risk 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.

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