Fin. Management 8 - Risk & Return Analysis

Fin. Management 8 - Risk & Return Analysis - Hult...

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Hult International Business School - Shanghai Financial Management April/May 2015 Handout 8 – Risk & Return Analysis
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1-2 -2- Risk … What is it ? “Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).” -Wikipedia. (Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility.” - Oxford English Dictionary.
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1-3 -3- Risk … and Reward / Return In fact, in finance risk is inherently linked with rewards; One does not exist without the other (if you are a rational individual). You take risk because you want to be compensated for taking risk. The question becomes .. How do we represent risk and rewards ? or How do we model risk and return ? 1. How much danger is in the investment ? 2. How much opportunity is there to compensate for that danger ?
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1-4 -4- Risk and Return Models The following are key questions when assessing how good a Risk & Return model is ... 1. Does it specify/explain what kinds of risks are getting returns, and what kinds are not ? 2. Does it show risk in a standardized form ? Is it easy to understand ? Can it be assessed whether the specified risk is below or above average ? 3. Does it transform the risk into a rate of return which compensates the risk ? 4. Is it applicable to all/various assets (asset classes) or is it asset specific ? 5. Does it statistically work ? (by explaining historical returns). How good is it in predicting the future ?
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1-5 -5- Capital Asset Pricing Model (CAPM) 1. Measures risk as a function of : Expected return, and Variance of actual returns. 2. Specifies that only the non-diversifiable (systematic) portion of risk will be rewarded. 3. Used Beta (β) (which is standardized) to measure the non-diversifiable risk. 4. Defines that there is a riskless portion of return (reward for TVM). 5. Translates 1, 2, 3, 4, (above) into expected return. 6. Works as well as any other alternative. (CAPM) E(Ri ) = Rf + βi [E(RM ) - Rf ]
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1-6 -6- CAPM – A Mean Variance Model CAPM assumes that preferences depend only on the mean and variance of payoffs and not on other features. - Is it a reasonable assumption ? Expected return: weighted average of the distribution of possible returns in the future. Variance of returns: a measure of the dispersion of the distribution of possible returns in the future. Both (above) are based on historical calculations. Historical calculations show that: 1. Over a long time period, on average, the higher the risk of the asset, the higher the (expected) return. 2. The risk (variance) (in any given year) goes up as the expected return goes up.
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