chapter11a - Chapter 11 Risk and Return Goals Understand...

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Chapter 11 Risk and Return Goals Understand the impact of diversification Understand the systematic risk principle Understand SML and CAPM
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4 Expected Returns Expected returns are based on the probabilities of possible outcomes In this context, “expected” means “average” if the process is repeated many times Example: suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession 0.2 0.02 0.01 = = n i i i R p R E 1 ) (
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5 Variance and Standard Deviation Variance and standard deviation measure the volatility of returns Weighted average of squared deviations Example: consider the previous example. What are the variance and standard deviation for each stock? Stock C: Stock T: = - = n i i i R E R p 1 2 2 )) ( ( σ
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6 Portfolios A portfolio is a collection of assets The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets Example: suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? $2,000 of DCLK $3,000 of KO $4,000 of INTC $6,000 of KEI
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7 Portfolio Expected Returns The expected return of a portfolio is the weighted average of the expected returns of the respective assets in the portfolio. You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities. Example: Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio? DCLK: 19.65%, KO: 8.96%, INTC: 9.67%, KEI: 8.13% = = m j j j P R E w R E 1 ) ( ) (
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8 Portfolio Variance Compute the portfolio return for each state: R P = w 1 R 1 + w 2 R 2 + … + w m R m Compute the expected portfolio return using the same formula as for an individual asset Compute the portfolio variance and standard deviation using the same formulas as for an individual asset
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chapter11a - Chapter 11 Risk and Return Goals Understand...

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