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Unformatted text preview: CHAPTER 6 The Meaning and Measurement of Risk and Return CHAPTER ORIENTATION In this chapter, we examine the factors that determine rates of return (discount rates) in the capital markets. We are particularly interested in the relationship between risk and rates of return. We look at risk both in terms of the riskiness of an individual security and that of a portfolio of securities. CHAPTER OUTLINE I. Expected Return Defined and Measured A. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates. B. Conventionally, we measure the expected cash flow, _ X , as follows: _ X = P(X 1 )X 1 + P(X 2 )X 2 + + P(X n )X n where n = the number of possible states of the economy X i = the cash flow in the ith state of the economy P(X i ) = the probability of the ith cash flow II. Risk Defined and Measured A. Risk can be defined as the possible variation in cash flow about an expected cash flow. B. Statistically, risk may be measured by the standard deviation about the expected cash flow. 200 III. Rates of Return: The Investors Experience A. Data have been compiled by Ibbotson and Associates on the actual returns for various portfolios of securities from 1926-1998. B. The following portfolios were studied: 1. Common stocks of large firms 2. Common stocks of small firms 3. Corporate bonds 4. Long-term U.S. government bonds 5. Intermediate U.S. government bonds 6. U.S. Treasury bills C. Investors historically have received greater returns for greater risk-taking with the exception of the long-term U.S. government bonds. D. The only portfolio with returns consistently exceeding the inflation rate has been common stocks. IV. Risk and Diversification A. The market rewards diversification. We can lower risk without sacrificing expected return, and/or we can increase expected return without having to assume more risk. B. Diversifying among different kinds of assets is called asset allocation. Compared to diversification within the different asset classes, the benefits received are far greater through effective asset allocation. C. Total variability can be divided into: a. The variability of returns unique to the security (diversifiable or unsystematic risk) b. The risk related to market movements (nondiversifiable or systematic risk) D. By diversifying, the investor can eliminate the "unique" security risk. The systematic risk, however, cannot be diversified away. E. Measuring Market Risk 1. The characteristic line tells us the average movement in a firm's stock price in response to a movement in the general market, such as the S&P 500 Index. The slope of the characteristic line, which has come to be called beta , is a measure of a stock's systematic or market risk. The slope of the line is merely the ratio of the "rise" of the line relative to the "run" of the line....
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