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Unformatted text preview: Risk and Rates of Return Chapter 8 StandAlone Risk Portfolio Risk Risk and Return: CAPM/SML 81 Investment Returns The rate of return on an investment can be calculated as follows: 82 ( 29 Cost Cost value ending Expected Return = What is investment risk? Two types of investment risk Standalone risk Portfolio risk Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. 83 Probability Distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 1570 Firm X Firm Y 84 Which firm is riskier? Selected Realized Returns, 19262007 Average Standard Return Deviation Smallcompany stocks 17.1% 32.6% Largecompany stocks 12.3 20.0 LT corporate bonds 6.2 8.4 LT government bonds 5.8 9.2 U.S. Treasury bills 3.8 3.1 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008), p28. 85 Investment Alternatives Economy Prob. TBill HT Coll USR MP Recession 0.1 5.5%27.0% 27.0% 6.0%17.0% Below avg 0.2 5.5%7.0% 13.0%14.0%3.0% Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0% Above avg 0.2 5.5% 30.0%11.0% 41.0% 25.0% Boom 0.1 5.5% 45.0%21.0% 26.0% 38.0% 86 Why is the Tbill return independent of the economy? Do Tbills promise a completely risk free return? Tbills will return the promised 5.5%, regardless of the economy. No, Tbills do not provide a completely riskfree return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time. Tbills are also risky in terms of reinvestment rate risk. Tbills are riskfree in the default sense of the word. 87 How do the returns of HT and Coll. behave in relation to the market? HT Moves with the economy, and has a positive correlation. This is typical. Coll. Is countercyclical with the economy, and has a negative correlation. This is unusual. 88 Calculating the Expected Return 89 r = E xpected rate of return r = r i P i i=1 N r = (27%)(0.1) + (7%)(0.2) + (15%)(0.4) + (30%)(0.2) + (45%)(0.1) =12.4% r = r bar = r = realized, historical (past) rate of return Summary of Expected Returns Expected return (aka r hat) HT 12.4% Market 10.5% USR 9.8% Tbill 5.5% Coll. 1.0% HT has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk?...
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 Spring '08
 ZHOU

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