chap13

# chap13 - Chapter 13 Chapter Return Risk and the Return...

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Chapter 13 Chapter 13 Return, Risk and the Return, Risk and the Security Market Line Security Market Line

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13-2 FIN 3716 Key Concepts and Skills Key Concepts and Skills Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand the security market line Understand the risk-return trade-off Be able to use the Capital Asset Pricing Model
13-3 FIN 3716 Chapter Outline Chapter Outline Expected Returns and Variances Portfolios Announcements, Surprises, and Expected Returns Risk: Systematic and Unsystematic Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital: A Preview

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13-4 FIN 3716 Expected Returns 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 The “expected” return does not even have to be a possible return = = n i i i R p R E 1 ) (
13-5 FIN 3716 Example: Expected Returns Example: Expected Returns 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 15 25 Normal 0.5 10 20 Recession ??? 2 1 R C = .3(15) + .5(10) + .2(2) = 9.9% R T = .3(25) + .5(20) + .2(1) = 17.7%

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13-6 FIN 3716 Variance and Standard Deviation Variance and Standard Deviation Variance and standard deviation still measure the volatility of returns Using unequal probabilities for the entire range of possibilities Weighted average of squared deviations = - = n i i i R E R p 1 2 2 )) ( ( σ
13-7 FIN 3716 Example: Variance and Standard Example: Variance and Standard Deviation Deviation Consider the previous example. What are the variance and standard deviation for each stock? Stock C σ 2 = .3(15-9.9) 2 + .5(10-9.9) 2 + .2(2-9.9) 2 = 20.29 σ = 4.5 Stock T σ 2 = .3(25-17.7) 2 + .5(20-17.7) 2 + .2(1-17.7) 2 = 74.41 σ = 8.63

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13-8 FIN 3716 Another Example Another Example Consider the following information: State Probability ABC, Inc. (%) Boom .25 15 Normal .50 8 Slowdown .15 4 Recession .10 -3 What is the expected return? What is the variance? What is the standard deviation?
13-9 FIN 3716 Portfolios Portfolios A portfolio is a collection of assets An asset’s risk and return are important in how they affect the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

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13-10 FIN 3716 Example: Portfolio Weights Example: Portfolio Weights Suppose you have \$15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security?
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