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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 stand-alone 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.
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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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