FFM CH8 - Risk and Rates of Return Chapter 8 Stand-Alone...

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Unformatted text preview: Risk and Rates of Return Chapter 8 Stand-Alone Risk Portfolio Risk Risk and Return: CAPM/SML 8-1 Investment Returns The rate of return on an investment can be calculated as follows: 8-2 ( 29 Cost Cost value ending Expected Return- = What is investment risk? Two types of investment risk Stand-alone 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. 8-3 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 15-70 Firm X Firm Y 8-4 Which firm is riskier? Selected Realized Returns, 1926-2007 Average Standard Return Deviation Small-company stocks 17.1% 32.6% Large-company stocks 12.3 20.0 L-T corporate bonds 6.2 8.4 L-T 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. 8-5 Investment Alternatives Economy Prob. T-Bill 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% 8-6 Why is the T-bill return independent of the economy? Do T-bills promise a completely risk- free return? T-bills will return the promised 5.5%, regardless of the economy. No, T-bills do not provide a completely risk-free return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time. T-bills are also risky in terms of reinvestment rate risk. T-bills are risk-free in the default sense of the word. 8-7 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. 8-8 Calculating the Expected Return 8-9 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% T-bill 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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FFM CH8 - Risk and Rates of Return Chapter 8 Stand-Alone...

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