chap08 - Chapter 8 1 Based on annual returns from 1926 2004...

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Chapter 8 1
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Based on annual returns from 1926-2004 Avg. Return Std Dev. Small Stocks 17.5% 33.1% Large Co. Stocks 12.4% 20.3% L-T Corp Bonds 6.2% 8.6% L-T Govt. Bonds 5.8% 9.3% U.S. T-Bills 3.8% 3.1% 2
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Risk: The Big Picture Expected Return Stand Alone Risk Portfolio Return and  Risk Risk Diversification Market Risk Beta CAPM/Security  Market Line Equation  (SML) 3
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Risk  is an uncertain outcome or chance  of an adverse outcome. Concerned with the riskiness of cash  flows from financial assets. Stand Alone Risk:  Single Asset relevant risk measure is the  total risk  of  expected cash flows measured by  standard  deviation  . 4
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Portfolio Context:  A group of assets.   Total risk consists of: Diversifiable Risk (company-specific,  unsystematic) Market Risk (non-diversifiable, systematic) Small group of assets with Diversifiable  Risk remaining: interested in portfolio  standard deviation.  correlation ( ρ  or r) between asset returns  which affects portfolio standard deviation 5
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Well-diversified Portfolio Large Portfolio (10-15 assets) eliminates  diversifiable risk for the most part. Interested in  Market Risk  which is the risk  that cannot be diversified away. The relevant risk measure is  Beta  which  measures the riskiness of an individual  asset in relation to the market portfolio. 6
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HPR = (End of Period Price - Beginning  Price  + Dividends)/Beginning Price HPR = Capital Gains Yield + Dividend Yield HPR = (P1-P0)/P0 + D/P0 Example:  Bought at $50, Receive $3 in  dividends, current price is $54 HPR = (54-50+3)/50 = .14 or 14% CGY = 4/50 = 8%, DY = 3/50 = 6% 7
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Expected Rate of Return given a  probability distribution of possible  returns(r i ): E(r)          n E(r) =  Σ
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