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Unformatted text preview: 81 Chapter 8  Risk and Rates of Return Learning Objectives After reading this chapter, students should be able to: Define risk and calculate the expected rate of return, standard deviation, and coefficient of variation for a probability distribution. Specify how risk aversion influences required rates of return. Graph diversifiable risk and market risk; explain which of these is relevant to a welldiversified investor. State the basic proposition of the Capital Asset Pricing Model (CAPM) and explain how and why a portfolios risk may be reduced. Explain the significance of a stocks beta coefficient, and use the Security Market Line to calculate a stocks required rate of return. List changes in the market or within a firm that would cause the required rate of return on a firms stock to change. Identify concerns about beta and the CAPM. Explain the implications of risk and return for corporate managers and investors. 82 CHAPTER 8 Risk and Rates of Return Standalone risk Portfolio risk Risk & return: CAPM / SML 83 Investment returns The rate of return on an investment can be calculated as follows: (Amount received Amount invested) Return = ________________________ Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100  $1,000) / $1,000 = 10%. 84 What is investment risk? Two types of investment risk Standalone risk Portfolio risk Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. 85 Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 1570 Firm X Firm Y 86 Selected Realized Returns, 1926 2004 Average Standard Return Deviation Smallcompany stocks 17.5% 33.1% Largecompany stocks 12.4 20.3 LT corporate bonds 6.2 8.6 LT government bonds 5.8 9.3 U.S. Treasury bills 3.8 3.1 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28. 87 Investment alternatives Economy Prob. TBill HT Coll USR MP Recession 0.1 5.5%27.0% 27.0% 6.0%17.0% Below avg 0.2 5.5%7.0% 13.0%14.0%3.0% Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0% Above avg 0.2 5.5% 30.0%11.0% 41.0% 25.0% Boom 0.1 5.5% 45.0%21.0% 26.0% 38.0%...
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This note was uploaded on 07/18/2009 for the course FIN 3331 taught by Professor Nowacki during the Spring '09 term at Troy.
 Spring '09
 NOWACKI

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