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Unformatted text preview: Chapter 13 Chapter 13 Return, Risk and the Return, Risk and the Security Market Line Security Market Line 132 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 riskreturn tradeoff Be able to use the Capital Asset Pricing Model 133 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 134 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 ) ( 135 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% 136 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 )) ( ( 137 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 2 = .3(159.9) 2 + .5(109.9) 2 + .2(29.9) 2 = 20.29 = 4.5 Stock T 2 = .3(2517.7) 2 + .5(2017.7) 2 + .2(117.7) 2 = 74.41 = 8.63 138 FIN 3716 Another Example Another Example Consider the following information: State Probability ABC, Inc. (%) Boom .25 15 Normal .50 8 Slowdown .15 4 Recession .103 What is the expected return? What is the variance? What is the standard deviation? 139 FIN 3716 Portfolios Portfolios A portfolio is a collection of assets An assets risk and return are important in how they affect the risk and return of the portfolio The riskreturn tradeoff for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets 1310 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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This note was uploaded on 12/14/2010 for the course FIN 3716 taught by Professor Fang during the Fall '10 term at LSU.
 Fall '10
 FANG
 Finance

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