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Chapter 8

# Chapter 8 - CHAPTER 8 Risk and Rates of Return Stand-alone...

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8-1 Click to edit Master subtitle style n CHAPTER 8 Risk and Rates of Return n Stand-alone risk n Portfolio risk n Risk & return: CAPM / SML

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8-2 n Investment returns The rate of return on an investment can be  calculated as follows: (Amount received – Amount  invested) Return =       ________________________                                                    Amount
8-3 n What is investment risk? n Two types of investment risk n Stand-alone risk n Portfolio risk  n Investment risk is related to the probability  of earning a low or negative actual return. n The greater the chance of lower than  expected or negative returns, the riskier the

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8-4 n Probability distributions n A listing of all possible outcomes, and the  probability of each occurrence. Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y
8-5 n Investment alternatives Economy Prob. T-Bill HT Coll USR MP Recessio n 0.1 5.5% -27.0% 27.0%   6.0% -17.0% Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0% Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0% Above  avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0% Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%

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8-6 n Why is the T-bill return independent  of the economy?  Do T-bills promise a  n T-bills will return the promised 5.5%, regardless  of the economy. n No, T-bills do not provide a completely risk-free  return, as they are still exposed to inflation.   Although, very little unexpected inflation is likely  to occur over such a short period of time. n T-bills are also risky in terms of reinvestment rate  risk. n T-bills are risk-free in the default sense of the
8-7 n How do the returns of HT and Coll.  behave in relation to the market? n HT – Moves with the economy, and has  a positive correlation.  This is typical. n Coll. – Is countercyclical with the  economy, and has a negative  correlation.  This is unusual.

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8-8 n Calculating the expected return
8-9 n Summary of expected  returns      Expected return HT    12.4% Market    10.5% USR     9.8% T-bill     5.5% Coll.     1.0% HT has the highest expected return, and appears  to be the best investment alternative, but is it

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8-10 n Calculating standard deviation deviation   Standard = σ 2 Variance σ = = σ i 2 N 1 i i P ) r (r σ = - = ˆ
8-11 n Standard deviation for each investment

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8-12 n Standard Deviation for HT
8-13 n Comparing standard deviations USR Prob.

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Chapter 8 - CHAPTER 8 Risk and Rates of Return Stand-alone...

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