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Chapter 10 notes - Standalonerisk Portfoliorisk...

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1 CHAPTER 5   Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML
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2 Investment returns The rate of return on an investment can be  calculated as follows: For example, if $1,000 is invested and $1,100 is  returned after one year, the rate of return for this  investment is:       ($1,100 - $1,000) / $1,000 = 10%.
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3 What is investment 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. Two types of investment risk Stand-alone risk: all our money is tied to a single  asset Portfolio risk : Asset is held as one of many assets  in the portfolio
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4 Probability distributions A listing of all  possible outcomes,  and the probability  of each occurrence. Can be shown  graphically.
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5 Selected Realized Returns, 1926 – 2001
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6 T-bills   T-bills will return the promised return,  regardless of the economy. T-bills do not provide a 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.
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7 Example: Investment alternatives
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8 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.
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9 Expected Return   Weighted average Weights are probabilities Weights add up to 1
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10 Measuring Stand-alone Risk   Calculating the standard deviation for each alternative standard deviation is the square root of variance. It has  same unit as expected return
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11 Comparing standard deviations
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12 Comments on standard deviation as a measure of  risk Standard deviation ( σ i ) measures total, or  stand-alone, risk. The larger  σ i  is, the lower the probability that  actual returns will be closer to expected  returns. Larger  σ i  is associated with a wider  probability distribution of returns. Difficult to compare standard deviations,  because return has not been accounted for.
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13 Investor attitude towards risk Risk aversion – assumes investors dislike  risk and require higher rates of return to  encourage them to hold riskier securities.
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