Risk and Rates of Return

# Risk and Rates of Return - Risk and Rates of Return Chapter...

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Risk and Rates of Return Chapter 8 8-1

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Learning Objectives 7-2 Stand-Alone Risk Portfolio Risk Risk and Return: CAPM/SML
What is investment risk? Two types of investment risk Stand-alone risk Portfolio risk Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. 8-3

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Probability Distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. 8-4 Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y
Selected Realized Returns, 1926- 2009 8-5

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Hypothetical Investment Alternatives Economy Pro b. T-Bills 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 % 8-6
Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return? T-bills will return the promised 5.5%, regardless of the economy. 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. T-bills are also risky in terms of reinvestment risk. T-bills are risk-free in the default sense of the word. 8-7

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How do the returns of High Tech and Collections behave in relation to the market? High Tech: Moves with the economy, and has a positive correlation. This is typical. Collections: Is countercyclical with the economy, and has a negative correlation. This is unusual. 8-8
Calculating the Expected Return 8-9 12.4% (0.1)(45%) (0.2)(30%) (0.4)(15%) (0.2)(-7%) -27%) )( 1 . 0 ( r ˆ r P r ˆ return of rate Expected r ˆ N 1 i i i

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Summary of Expected Returns Expected Return High Tech 12.4% Market 10.5% US Rubber 9.8% T-bills 5.5% Collections 1.0% High Tech has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk? 8-10
Calculating Standard Deviation 8-11 N 1 i i 2 2 P ) r ˆ r ( Variance deviation Standard

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Standard Deviation for Each Investment 8-12 % 0 . 0 ) 1 . 0 ( ) 5 . 5 5 . 5 ( ) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 4 . 0 ( ) 5 . 5 5 . 5 ( ) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 1 . 0 ( ) 5 . 5 5 . 5 ( P ) r ˆ r ( bills - T 2 / 1 2 2 2 2 2 bills - T N 1 i i 2 σ M = 15.2% σ USR = 18.8% σ Coll = 13.2% σ HT = 20%
Comparing Standard Deviations 8-13 USR Prob. T-bills HT 0 5.5 9.8 12.4 Rate of Return (%)

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Comments on Standard Deviation as a Measure of Risk Standard deviation (σ i ) measures total, or stand-alone, risk. The larger σ i is, the lower the probability that actual returns will be closer to expected returns.
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