ch 08 (risk)

# ch 08 (risk) - A 1 B C D E F Chapter 8 Risk and Rates of...

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Chapter 8. Risk and Rates of Return 12/11/08 Table 8-1. Probability Distributions and Expected Returns Martin Products U.S. Water Rate of Rate of Economy, Probability Return Probability Return Which of This If This of This If This Affects Demand Demand Product Demand Demand Product Demand Occurring Occurs (2)x(3) Occurring Occurs (5)x(6) (1) (2) (3) (4) (5) (6) (7) Strong 0.30 80% 24% 0.30 15% 4.5% Normal 0.40 10% 4% 0.40 10% 4.0% Weak 0.30 -60% -18% 0.30 5% 1.5% 1.00 Expected return= 10% 1.00 Expected return= 10% We use Excel to do the calculations shown in black boldface type. TABLE 8-2. Calculating Martin Product’s Standard Deviation Rate of Deviation: Economy, Probability Return Actual - Which of This If This 10% Squared Affects Demand Demand Expected Deviation Deviation Demand Occurring Occurs Return Squared x Prob. (1) (2) (3) (4) (5) (6) Strong 0.30 80% 70% 0.4900 0.1470 Normal 0.40 10% 0% 0.0000 0.0000 Weak 0.30 -60% -70% 0.4900 0.1470 1.00 ∑ = Variance: 0.29 Standard deviation = square root of variance: σ = 0.5422 Standard deviation expressed as a percentage: σ = 54.2% TABLE 8-3. Finding σ Based On Historical Data Deviation from Squared Year Return Average Deviation The higher a security's risk, the higher its required return. Risk can be thought of in two ways: (1) Stand-alone risk, where the security is considered in isolation, and (2) portfolio risk, where the security's risk is thought of as its contribution to a well- diversified portfolio. In theory, only portfolio risk is important, but in practice both are important. Tables 8-1, 8-2, and 8-3 all pertain to stand-alone risk, after which we move on to portfolio risk. The standard deviation, σ, measures the variability of possible returns around the mean, or expected return. We demonstrate its calculation in Table 8-2. Excel paste functions are available for finding σ for an entire population (STDEVP) or a sample from the population (STDEV), but not for finding σ with probabilities as in this case. With probabilities you must go through the indicated calculations.

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ch 08 (risk) - A 1 B C D E F Chapter 8 Risk and Rates of...

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