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Bus320p.8 - Chapter 8 Risk and Rates of Return We are risk...

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Chapter 8 – Risk and Rates of Return We are risk averse, meaning we take risk only if the expected  return is high  enough to compensate us for the risk. The riskiness of an asset is determined by the riskiness of its cash flows.  All  financial assts are expected to produce cash flows. The risk of an asset can be viewed in two ways: 1) On a stand-alone basis: the risk of holding only one asset. 2) In the context of a portfolio. Two components of portfolio risk: 1) Diversifiable Risk: can be virtually eliminated through proper diversification. 2) Market Risk: reflects the risk of the general stock market; cannot be  eliminated by diversification. Probability Distributions Product Demand Probability Rate of Return (ROR)      Strong      .3        30%      Normal      .5        12%      Weak      .2         -15%                    1.0                          Expected ROR = k = (.3)(30%) + (.5)(12%) + (.2)(-15%) =  12% Find Standard Deviation:                       ROR   k Prob.   30% - 12%  = 18%       (18) 2  = 324  x   .3        =   97.2 12% - 12%  =   0%       ( 0)   =    0  x   .5        =     0.0         -15% - 12%  = -27%       (27)  = 729 x   .2        =  145.8 =  243.0  =    σ 2 Standard Deviation =  σ  = square root (243.0) =   15.6%
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Interpretation Returns will be w/in 1 stand. dev. of expected return 68% of the time: -3.6%   to   27.6% Returns will be w/in 2 stand. devs. of expected return 96% of the time: -19.2%  to   43.2% Returns will be w/in 3 stand. devs. of expected return 99.7% of the time: -34.8%  to   58.8% Coefficient of Variation (CV)
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