FIN 371: Financial Management CHAPTER 11: RISK AND RETURN PROFESSOR JARED I. WILSON
Chapter 11 – Objectives • CALCULATE EXPECTED RETURNS AND STOCK VARIANCE • DESCRIBE THE IMPACT OF DIVERSIFICATION • DIFFERENTIATE SYSTEMATIC AND UNSYSTEMATIC RISK • CALCULATE THE SECURITY MARKET LINE
Historical Average vs. Expected Return • Both provide useful insight about assets of interest • Historical average return • Does not take into consideration possible economic outcomes • Can give some insight about the future • BUT , not perfect • We want to know what will happen in the future • Expected return
Expected Returns • Weighted average of the possible outcomes based on the probability that each outcome will occur • Realized return may be very different from expected return • Expected return
Expected Returns Example • Determine the expected returns of the following: • U.S. Treasury Bill (risk-free rate) • Alphabet (technology firm) • Pepsi (beverage & food company) • Wal-Mart (retailer) • S&P 500 (stock market index)
Expected Returns Example • Probability distribution of stock returns Economy Probability T-Bill Alphabet Pepsi Wal-Mart S&P 500 Recession 10% Below average 20% Average 40% Above average 20% Boom 10% 100%
Expected Returns Example
Expected Returns Example •What is the expected risk premium?
Expected Returns In Class Problem •Suppose that you have predicted the following returns for stocks C and T in three possible states of nature•What is the probability of a recession?•What are the expected returns of stocks C and T?•If the risk-free rate is 2.5%, what is each stock’s risk premium?StateProbabilityCTBoom30%15%25%Normal50%10%20%Recession???2%1%
Expected Returns In Class Problem •What is the probability of a recession?•What are the expected returns of stocks C and T?•If the risk-free rate is 2.5%, what is each stock’s risk premium?
Variance and Standard Deviation • Variance and standard deviation measure volatility of returns • Now we have to consider the probability of different outcomes • Weighted average of squared deviations
Variance Example • Calculate the variance of Alphabet’s possible returns Economy Probability (A) Returns (B) Expected Return (C) Deviation (D)=(B)-(C) Squared Deviation (E)=(D) 2 Probability x Squared Deviation (F)=(A)x(E) Recession 10% -22.0% 17.4% Below average 20% -2.0% 17.4% Average 40% 20.0% 17.4% Above average 20% 35.0% 17.4% Boom 10% 50.0% 17.4% 100%
Variance Example • Calculate the variance of Pepsi’s possible returns Economy Probability (A) Returns (B) Expected Return (C) Deviation (D)=(B)-(C) Squared Deviation (E)=(D) 2 Probability x Squared Deviation (F)=(A)x(E) Recession 10% 28.0% 1.74% Below average 20% 14.7% 1.74% Average 40% 0.0% 1.74% Above average 20% -10.0% 1.74% Boom 10% -20.0% 1.74% 100%
Variance In Class Problem
You've reached the end of your free preview.
Want to read all 60 pages?
- Summer '19
- Capital Asset Pricing Model, Modern portfolio theory