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FIN 221 Lecture 4
CH7:RISK and RETURN
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Manual for FIN221 Assignment
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Extra Tute Qs for next week
•
In relation to the CAPM, indicate for each of the following
statements whether it is true or false and explain why.
(a) In equilibrium, all risky assets are priced such that their
expected return lies on the security market line.
(b) Two securities with the same required returns can have
different betas.
(c) Two securities with the same standard deviations can have
different betas.
(d) Two securities that have the same correlation coefficients
with the market portfolio will have the same beta.
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Relevant Reading Chapters
•7
.1
.2
.3

Calculating variance and standard deviation
‐
Interpreting variance and standard deviation
.4
.5
.6
.7
–Secur
ity Market Line
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Asset Valuation
CF
=
PV
(1+i)
CF
CF
2
CF
3
CF
n
∑
n
k=1
K
CF CF
1
k
• What are the three key variables needed in asset
valuation?
–
Future Cash flows
–
Discount rate
–
No of periods
Å
reflects the level of
risk
associated
with future cash flows
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Cash Flow
Cash Flow
Cash Flow
PV
PV
PV
(1+i)
n
R
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What are we learning today?
•
How do we determine “
required rate of
return for shareholders (=cost of equity)
”?
• Relation between
RISK and RETURN
• Computation of Expected Return
for
Definition and
quantification of total risk
for
i)
Individual securities
ii) Portfolios of securities
• Demonstrate how portfolios reduce risk
• Is there a
pricing model
which can explain or
predict the required rate return for a stock?
– Capital Asset Pricing Model
YES
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Definitions
• Portfolio (P)
– The collection of assets an investors owns
• Probability
– The chance that the event will occur
– Must sum to 1 or 100%
Stock i
i
2
i
3
i
4
i
1
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Total Holding Period Return (R
T
)
• When people refer to the return from an
investment, they are generally referring to the
TOTAL RETURN over some investment period
or
holding period
Æ
Total holding period return
26.5
28
P
0
P
1
CF
1
=$1
10
1
T
0
PP C
F
R
P
−+
=
Return from capital
appreciation=R
CA
Return from
Income=R
I
__________
=
10
Expected Returns
• An average of the possible returns from an
investment, where each return is weighted by the
probabilility that it will occur
• Can be computed using two types of data
– Probability data
– Historical data
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Expected Return : Single Asset (i)
Probability Data
E(R
Asset
)=
P
i
x
R
i
9%
10%
11%
12%
13%
0.1
R
i
P
i
n
i=1
∑
E(R
Asset
)=
()(
0.09
) +
0.10
) +
0.11
) +
0.12
) +
0.13
)
=
___%
0.2
0.4
0.2
0.1
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Expected Return : Single Asset (i)
Historical Data
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 Spring '10
 ala
 Capital Asset Pricing Model, Ri

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