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# wk11_12 - EC150 FININCIAL ECONOMICS Slide Set 7 Risk Return...

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EC150: FININCIAL ECONOMICS EC150: FININCIAL ECONOMICS Slide Set 7: Risk, Return, and Discount Rates (BASED ON RWJ CHAPTERS 9 AND10)

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How are risk and expected return How are risk and expected return related? related? There are two main reasons to be concerned with this question. (1) When conducting discounted cash flow analysis, how should we adjust discount rates to allow for riskiness in the cash flow projections? (2) When saving/investing , what is the tradeoff between taking risks and our
Reminder: Rates of Return Reminder: Rates of Return Returns have two components: Dividends (or Interest) Capital Gains (Price Appreciation) The percentage return (R) on an asset is defined as: t t t t t P P P D R - + = + + + 1 1 1 If we wait until we see the outcomes we are describing a If we wait until we see the outcomes we are describing a realized return realized return . . If we do the computation based on forecasts If we do the computation based on forecasts (expectations) we are describing an (expectations) we are describing an expected return expected return . We have to make our decisions based on expected returns, We have to make our decisions based on expected returns, but realized returns often contain useful information for but realized returns often contain useful information for forming our expectations.

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Suppose that you purchased a share of Intel for \$100 at the beginning of the year. During the year Intel paid \$3.50 in dividends and the price at the end of the year was \$110. What was your return (R) for the year? Answer: R = (3.5+[110-100])/100 = 3.5/100 + 10/100 = 3.5% + 10% = 13.5%. Rate of Return Example: Rate of Return Example:
There is general agreement that average returns should increase with risk. Average Return Risk But, how should risk be measured? at what rate does the line slope up? is the relation linear? Lets look at some key historical evidence.

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The Value of an Investment of \$1 in 1926 Source: Ibbotson Associates 0.1 10 1000 1925 1933 1941 1949 1957 1965 1973 1981 1989 1997 S&P Small Cap Corp Bonds Long Bond T Bill Index Year End 1 5520 1828 55.38 39.07 14.25
We see big differences in average realized We see big differences in average realized returns across assets. But risk also differed. returns across assets. But risk also differed. How can we assess risk? How can we assess risk? Many people think intuitively about risk as the possibility of an outcome which is worse than anticipated. For those who hold more than one asset, is it the risk of each asset they care about, or the risk of the portfolio? A useful construct for thinking rigorously about risk: the “probability distribution” A list of all possible outcomes and their probabilities.

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Example: Two Probability Distributions Example: Two Probability Distributions on Tomorrow's Share Price. on Tomorrow's Share Price.
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wk11_12 - EC150 FININCIAL ECONOMICS Slide Set 7 Risk Return...

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