Chapter11.ppt - Chapter 11 RETURN AND RISK THE CAPITAL ASSET PRICING MODEL(CAPM Class Problem Consider the following scenario Scenario Probability Stock

# Chapter11.ppt - Chapter 11 RETURN AND RISK THE CAPITAL...

• 47

This preview shows page 1 - 12 out of 47 pages.

RETURN AND RISK: THE CAPITAL ASSET PRICING MODEL (CAPM) Chapter 11 11-2 Class Problem Consider the following scenario:ScenarioProbabilityStock Return Bond ReturnRecession.20-5%+14%Normal .60+15%+8%Boom.20+25%+4%Calculate the expected return and standard deviation of returns for stocks. 2 11-3 Class Problem con’t Scenario Probability Stock Return Bond Return Recession .20 -5% +14% Normal .60 +15% +8% Boom .20 +25% +4% Calculate the expected return and standard deviation of returns for bonds.ER of bond = variance of bond = standard deviation Look at the way stock and bond returns move during recessions and booms. What does this mean for diversification in a portfolio of the two assets? = 3 11-4 Individual Securities For individual stocks we look at: Expected Return Variance and Standard Deviation Covariance and Correlation (to another security or index) 11-5 Covariance & Correlation Variance and Standard Deviation measure the variability of individual stocks. Covariance and Correlation Measure how 2 random variable are related . 5 11-6 Covariance Scenario Probability Stock Bond Deviations Product (1) x (4) (1) (2) (3) (4) Recession .20 -.18% .056% -.01008 - .002016 Normal .60 .02% - .004% -.00008 -.000048 Boom .20 .12% -.044% -.00528 -.001056 Covariance (Rstocks,Rbonds) = - .00312 Deviations from Exp Returns Product of Covariance: A measure of the degree to which returns on two risky assets move in tandem. If the covariance is negative, the two returns tend to move in opposite directions. If the covariance is positive, the two returns tend to move together. Negative Covariance shows negative relationship between stock & bond returns – one is usually above the average return when the other is below its average return The size of the number is hard to interpret because it is in squared deviation units 11-7 Correlation 9949 . 0 ) 032 )(. 098 (. 00312 . ) , ( b a b a Cov Correlation: A statistic in which the covariance is scaled to a value between +1 to -1 11-8 Correlation 11-9 The Return and Risk for Portfolios Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks. Scenario Probability Stock Return Bond Return Recession .20 -5% +14% Normal .60 +15% +8% Boom .20 +25% +4% ER of stock = 13% variance of stock = 96 standard deviation = 9.8% ER of bond = 8.4% variance of bond = 10.24 standard deviation = 3.2%  11-11 The Efficient Set Definition:  • • • 