Risk_and_Required_Rates_of_Returnangel

Risk_and_Required_Rates_of_Returnangel - Understanding Risk...

Info iconThis preview shows pages 1–12. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Understanding Risk Concepts and Required Rates of Return A.J.Singh Session Overview Review of Key Concepts Related to Risk Definition Risk free Rate Risk Premium Risk Return Tradeoff Calculation of Expected Return Calculating Standard Deviation: A measure of Risk Risk Reduction through diversification Understanding Portfolios Market Risk (Systematic) Company Risk (Unsystematic) Beta: A measure of Market Risk KEY CONCEPTS RELATED TO RISK AND REQUIRED RATES OF RETURN How Do You Define Risk? The chance that an investments actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Components of Required Rates of Return Risk Free Rate of Return ( Rf) Lower rate Safety of principal When you invest in a riskier investment you expect to be paid more for incurring risk This is the risk premium over risk free rate. Greater risk requires a greater return kE= Rf + Risk Premium Risk-Return Tradeoff:No Additional Risk Unless Compensated With Additional Return Selecting between various investment choices based on risk-return trade-off Valuation of Investment Choices: Financial Assets: Stocks Real Assets: Real Estate Investments The value of an investment is based on expected return of that investment FOCUS ON RISK Consider a Lottery Your Bet Your Gain Odds: 1:10 Odds: 9:10 $1 $10 $10 $100 $100 $1000 $1000 $10,000 $10,000 $100,000 $100,000 $1,000,000 Components of Required Rates of Return How will you know what the risk premium that you should expect? Ans: Should = to similar risky investments Risk can also be categorized as: Business Risk: variability of cash flows Financial Risk: Due to debt financing kE = Rf +Business risk premium + Financial Risk Premium What else should an investor include in their required rate of return? Inflation Premium Nominal rate of return includes the inflation risk. Nom ina l Re tu rnsS tanda rd Dev ia tioRea l Re tu rn R isk P rem ium Sma ll S tocks 17 .60% 33 .60% 14 .40% 13 .80% La rge S tocks 13 .30% 20 .10% 10 .10% 9 .50% LT Co rpo ra te Bonds 5 .90% 8 .70% 2 .70% 2 .10% LT Gove rnmen t Bonds 5 .50% 9 .30% 2 .30% 1 .70% US T reasu ries 3 .80% 3 .20% 0 .60% 0 .00% Eat Well or Sleep Well? An adage that, referring to the risk/return trade- off, says that the type of security an investor chooses depends on whether he or she wants to eat well or sleep well. Investing in high-risk, high-reward securities will offer you the potential to eat well, but the risky nature of these securities might prevent you from sleeping at night. By contrast, investing safely means that you will sleep well, but the low rate of return may keep you from eating well. Growth % (Semi-Annual) 20 Year Period (Jan 1982 to Dec 2001)-10.0%-7.5%-5.0%-2.5% 0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1...
View Full Document

This note was uploaded on 09/10/2010 for the course IAH 001 taught by Professor Wang during the Spring '10 term at Michigan State University.

Page1 / 67

Risk_and_Required_Rates_of_Returnangel - Understanding Risk...

This preview shows document pages 1 - 12. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online