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CHAPTER 6
The Meaning and Measurement of Risk and Return
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.
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.
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 Spring '08
 Potts
 Interest

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