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Fin 101 Risk & Return

Fin 101 Risk & Return - Fin 101 Risk and Return...

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Fin 101 – Risk and Return, CAPM In this section of the Finance Review, measurement of risk and return is discussed. The Capital Asset Pricing Model, a financial model that relates risk and return is also reviewed. If you have additional questions, refer to the Brigham and Besley textbook used in Finance 101. RISK AND RETURN MEASUREMENT What is the return on an investment? An investor’s expected return is the average annual return s/he expects to earn by holding a security for a long period of time. What is the risk of investment? Risk is the chance that an outcome will differ from what investors expect to earn on average. Investments that offer the possibility of huge gains or losses have more risk than investments that offer small gains and losses. How are risk and return of an investment measured? First, all possible outcomes that a security can earn and the probability of earning that return must be defined. This is the probability distribution of returns. Expected return is defined as: () Σ = −== n1ii2i rˆrrˆ return of rate Expected Pr Variance and standard deviation are two risk measures used in Finance. These two statistics measure the distance between the return investors EXPECT to earn on average, and all possible returns that the investor could actually earn. Formulas for finding variance and standard deviation are: () Σ = == n1ii2i2 rˆ-r Variance Pr σ () Σ = == n1ii2i rˆ-rdeviation Standard Pr σ The coefficient of variation is a statistic that combines risk and return into a single measure. The formula for coefficient of variation is:
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r ˆReturnRisk = CV = variationoft Coefficienσ= Example 1: Finding the Risk and Return of a Security The probability distribution of a security’s returns are shown on the table below. Returns depend on how well the economy fares (boom, normal, recession).
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