(10) CH11 Lecture Slides.pptx - FIN 371 Financial Management CHAPTER 11 RISK AND RETURN PROFESSOR JARED I WILSON Chapter 11 Objectives CALCULATE

# (10) CH11 Lecture Slides.pptx - FIN 371 Financial...

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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 natureWhat 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.

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