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C
HAPTER
3
R
ISK AND
R
ETURN
OVERVIEW
Risk is an important concept in financial
analysis, especially in terms of how it affects
security prices and rates of return.
Invest
ment risk is associated with the probability
of low or negative future returns.
The riskiness of an asset can be con
sidered in two ways: (1) on a
standalone
basis,
where the asset’s cash flows are ana
lyzed all by themselves, or (2) in a
portfolio
context,
where the cash flows from a number
of assets are combined and then the consolid
ated cash flows are analyzed.
In a portfolio context, an asset’s risk can
be divided into two components:
(1) a
diver
sifiable risk component,
which can be diversi
fied away and hence is of little concern to di
versified investors, and (2) a
market risk com
ponent,
which reflects the risk of a general
stock market decline and which
cannot be eliminated by diversification, hence
does concern investors. Only market risk is
rel
evant
; diversifiable risk is irrelevant to most in
vestors because it can be eliminated.
An attempt has been made to quantify
market risk with a measure called
beta
. Beta is
a measurement of how a particular firm’s
stock returns move relative to overall move
ments of stock market returns. The
Capital
Asset Pricing Model (CAPM),
using the
concept of beta and investors’ aversion to risk,
specifies the relationship between market risk
and the required rate of return. This relation
ship can be visualized graphically with the Se
curity Market Line (SML). The slope of the
SML can change, or the line can shift upward
or downward, in response to changes in risk or
required rates of return.
OUTLINE
With most investments, an individual or business spends money today with the expectation
of earning even more money in the future.
The concept of return provides investors with a
convenient way of expressing the financial performance of an investment.
One way of expressing an investment return is in
dollar
terms
.
Dollar return = Amount received – Amount invested.
Expressing returns in dollars is easy, but two problems arise.
RISK AND RETURN
3  2
To make a meaningful judgment about the adequacy of the return, you
need to know the scale (size) of the investment.
You also need to know the timing of the return.
The solution to the scale and timing problems of dollar returns is to express investment res
ults as
rates of return
, or
percentage returns
.
Rate of return =
invested
Amount
invested
Amount
received
Amount

.
The rate of return calculation “normalizes” the return by considering the
return per unit of investment.
Expressing rates of return on an annual basis solves the timing problem.
Rate of return is the most common measure of investment performance.
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