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Unformatted text preview: 4  1 Risk and Return: The Theory Basic risk concepts Basic return concepts Standalone risk Portfolio (market) risk Risk and return: CAPM/SML 4  2 Two Games Game A: You are given $1000 and offered a coin toss. If you win, you get another $1000. Or you can receive $500 with no toss. Game B: You are given $2000 and offered a coin toss. If you lose, you pay $1000. Or you can pay $500 with no toss. Which Do You Choose? Game A: studies show 16% choose toss, 84% choose sure thing Game B: studies show 69% choose toss, 31% choose sure thing Which Does Theory Say You Choose? 4  3 What is investment risk? Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk. 4  4 Probability distribution Rate of return (%) 50 15 0 20 Asset X Asset Y Which asset is riskier? Why? 4  5 What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? Dollar return : $ Received  $ Invested $1,100  $1,000 = $100 . Percentage return : $ Return/$ Invested $100/$1,000 = 0.10 = 10% . 4  6 Assume the Following Investment Alternatives Economy Prob. TBill ADM Rural RE Am F. Mkt Recession 0.10 8.0% 22.0% 28.0% 10.0% 13.0% Below avg. 0.20 8.0 2.0 14.7 10.0 1.0 Average 0.40 8.0 20.0 0.0 7.0 15.0 Above avg. 0.20 8.0 35.0 10.0 45.0 29.0 Boom 0.10 8.0 50.0 20.0 30.0 43.0 1.00 4  7 Do the returns of ADM and Rural RE move with or counter to the economy? ADM moves with the economy, so it is positively correlated with the economy. This is the typical situation. Rural RE moves counter to the economy. Such negative correlation is unusual. 4  8 Calculate the expected rate of return on each alternative. ^ r = expected rate of return. r ADM = 0.10(22%) + 0.20(2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4% . ^ 4  9 ADM has the highest rate of return. Does that make it best? r ADM 17.4% Market 15.0 Am. Farm 13.8 Tbill 8.0 Rural RE 1.7 ^ 4  10 What is the standard deviation of returns for each alternative? 4  11 Tbills = 0.0%. ADM = 20.0%....
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 Fall '09
 slezak

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