6thCh8P - CHAPTER8 RiskandRatesofReturn Standalonerisk...

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1 CHAPTER 8 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML
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3 Return on Countrywide stock If you bought Countrywide stock at  $13.64 in 2003 and sold when in  peaked in January 2007 at $45, what  was your annualized return? If you held till July (4.5 years) and sold  at $28.17 what was your return. If you sold in January 2008 at $6.96,  what was your return?
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4 Risk and Return The return required on an investment  depends on the risk of the investment. What kind of risk results in higher  return? Returns from non-financial investments  have to be comparable with returns  from financial investments of similar  risk.
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5 Investment returns The rate of return on an investment can be  calculated as follows: (Amount received – Amount invested) Return =       ________________________                                                    Amount invested 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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7 7 Probability Distribution: Which  stock is riskier?  Why? -30 -15 0 15 30 45 60 Returns (% ) Stock A Stock B
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8 Annual Total Returns,1926-2007 Average Standard Return Deviation Distribution Small-company stocks 17.1% 32.6% Large-company stocks 12.3 20.0 Long-term corporate bonds 6.2 8.4 Long-term government 5.8 9.2 Intermediate-term government 5.8 5.7 U.S. Treasury bills 3.8 3.1 Inflation 3.2 4.5 0 17.4% 0 13.2% 0 6.1% 0 5.7% 0 5.5% 0 3.8% 0 3.2%
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10 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%
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11 Moving with or against the  market? HT:  Moves with the economy, and  has a  positive correlation. This is  typical. Coll:  Is countercyclical of the  economy, and has a   negative  correlation .  This is unusual.
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14 Calculating the expected return   12.4%     (0.1)   (45%)              (0.2)   (30%)     (0.4)   (15%)           (0.2)   (-7%)     (0.1)   (-27%)     r P   r       r         return   of   rate    expected     r HT ^ N 1 i i i ^ ^ = + + + + = = = =
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15 Summary of expected returns      Expected return 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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16 Standard Deviation for Each Investment % 0 . 0 ) 1 . 0 ( ) 5 . 5 5 . 5 ( ) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 4 . 0 ( ) 5 . 5 5 . 5 ( ) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 1 . 0 ( ) 5 . 5 5 . 5 ( P ) r ˆ r (                            bills - T 2 / 1 2 2 2 2 2 bills - T N 1 i i 2 = σ - + - + - - + - = σ - = σ = σ HT  = 20% σ M  = 15.2% σ USR  =  18.8% σ Coll  =  13.2% σ HT = { [ (-.27 -.124) 2 x.1] + [ (-.07 - .124) 2 x .2] + [ (.15 - .124) 2 x .4] + [ (.30 - .124) 2 x .2] + [ (.45-.124) 2 x.1]} .5 = (.1552 x .1 + .0376 x .2 + .0007 x .4 +.031 x .2 + .1063 x .1) .5 = ( .0401) .5 = .20 = 20.0 % The square root of . 0401 = . 20 = 20%, which is the standard deviation for HT (high tech)
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6thCh8P - CHAPTER8 RiskandRatesofReturn Standalonerisk...

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