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Unformatted text preview: 1 Finance 4310 Lecture 2 Risk and Return The Relationship between Risk and Return Based on observed behavior, it was long recognized that there is a positive relationship between risk and return Risk Return 2 Consider the Valuation Models = 1 D P g S K The return term appears in the denominator. If there is a positive relationship between return and risk, this indicates that rising risk will cause K to rise making the denominator larger and reducing will cause K S to rise, making the denominator larger and reducing P . Thus, rising risk results in falling asset prices. Finding a model of risk and return Prior to the 1960s there was no model Prior to the 1960s, there was no model quantifying this relationship. Risk adjustments were made using intuition, risk classes, etc. 3 How is Risk Defined in Finance? The probability that you will lose money? The probability that you will lose money? (No.) The variability of returns? (Yes) Measuring Return Variability Variance or standard deviation measures the variation about a mean value for a random variable. Considers upside as well as downside variations. We are pleased with upside variations for investments and dont tend to think of them as risky, but they fit the standard deviation definition. 4 Expected Value In the discussion of valuation models, we defined expected returns as estimates of future returns based on information future returns based on information available today. If we consider future returns as drawings from a probability distribution, we can attach mathematical precision to the concept of expected returns. Expected Value, Definition The expected value of returns is the weighted average of the expected future returns for each possible future state of nature. The weights are the probabilities of occurrence of each state of nature nature....
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 Spring '10
 Impson
 Valuation

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