# chap 5 - After reading this chapter students should be able...

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Unformatted text preview: After reading this chapter, students should be able to: • Define dollar return and rate of return. • 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 well-diversified investor. • State the basic proposition of the Capital Asset Pricing Model (CAPM) and explain how and why a portfolio’s risk may be reduced. • Explain the significance of a stock’s beta coefficient, and use the Security Market Line to calculate a stock’s required rate of return. • List changes in the market or within a firm that would cause the required rate of return on a firm’s stock to change. • Identify concerns about beta and the CAPM. • Explain how stock price volatility is more likely to imply risk than earnings volatility. Learning Objectives: 5 - 1 Chapter 5 Risk and Rates of Return LEARNING OBJECTIVES Risk analysis is an important topic, but it is difficult to teach at the introductory level. We just try to give students an intuitive overview of how risk can be defined and measured, and leave a technical treatment to advanced courses. Our primary goals are to be sure students understand (1) that investment risk is the uncertainty about returns on an asset, (2) the concept of portfolio risk, and (3) the effects of risk on required rates of return. What we cover, and the way we cover it, can be seen by scanning Blueprints , Chapter 5. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 5 - 2 LECTURE SUGGESTIONS 5-1 a. The probability distribution for complete certainty is a vertical line. b. The probability distribution for total uncertainty is the X-axis from- ∞ to + ∞ . 5-2 Security A is less risky if held in a diversified portfolio because of its negative correlation with other stocks. In a single-asset portfolio, Security A would be more risky because σ A > σ B and CV A > CV B . 5-3 a. No, it is not riskless. The portfolio would be free of default risk and liquidity risk, but inflation could erode the portfolio’s purchasing power. If the actual inflation rate is greater than that expected, interest rates in general will rise to incorporate a larger inflation premium (IP) and--as we shall see in Chapter 7--the value of the portfolio would decline. b. No, you would be subject to reinvestment rate risk. You might expect to “roll over” the Treasury bills at a constant (or even increasing) rate of interest, but if interest rates fall, your investment income will decrease....
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chap 5 - After reading this chapter students should be able...

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