04 -- Risk and Return

# 04 -- Risk and Return - 18 1 StandAloneRisk PortfolioRisk...

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Click to edit Master subtitle style Risk and Rates of Return Stand-Alone Risk Portfolio Risk Risk and Return: CAPM/SML 18- 1

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3/23/11 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:  28- 2 ( 29 Cost Cost    value ending   Expected   Return - = ( 29 1,100 1,000 Return 1,000 10% - = =
3/23/11 What is investment risk? Two types of investment risk Stand-alone risk The Risk an investor would face if he or she held only  one asset 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. 38- 3

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3/23/11 Probability Distributions A listing of all possible outcomes, and the  probability of each occurrence. Can be shown graphically. 48- 4 Expected Rate of  Return Rate of Return  (%) 10 0 15 0 -70 Firm  X Firm  Y
3/23/11 Selected Realized Returns, 1926-2007 Source:  Based on  Stocks, Bonds, Bills, and  Inflation:  (Valuation Edition) 2008 Yearbook (Chicago:  Morningstar, Inc., 2008), p28. 58- 5 Average  Return Standard  Deviation Small-co Stocks 17.1% 32.6% Large-co Stocks 12.3% 20.0% L-T Corp  Bonds 6.2% 8.4% L-T Gov Bonds 5.8% 9.2% US Treasure  Bills 3.8% 3.1%

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3/23/11 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% 68- 6
3/23/11 T-bill 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. 78- 7

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3/23/11 HT and Coll. movements 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- 8
3/23/11 Calculating the Expected Return 98- 9 Prob Return 0.1 -27 -2.7 0.2 -7 -1.4 0.4 15 6 0.2 30 6 0.1 45 4.5 Expect Return 12.4 1 N i i i r r P = = \$ ( 29 ( 29 ( 29 ( 29 ( 29 27%*0.1 7%*0.2 15%*0.4 30%*0.2 45%*0.1 12.4% r = - + - + + + = \$

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Summary of Expected Returns 10 8- 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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