Chapter8

Chapter8 - FIN3100:Chapter 8 Risk and Return Learning...

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FIN3100:Chapter 8 Risk and Return

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Learning Objectives 1. Calculate profits and returns on an investment. 2. Define risk and explain how uncertainty relates to risk. 3. Understand the difference between arithmetic and geometric return. 4. Appreciate the historical returns of various investment choices. 5. Calculate standard deviations and variances with historical data.
Objectives (continued) 6. Interpret the trade-off between risk and return. 1. Understand when and why diversification works at minimizing risk, and the difference between systematic and unsystematic risk. 2. Explain beta as a measure of risk.

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The Risk-Return Trade-Off We can examine returns in financial markets to help us determine the appropriate returns for any asset. Investors want to maximize return and minimize risk. Lesson from capital market history: There is a reward for bearing risk and the greater the potential reward, the greater the risk.
Dollar Profits and Percentage  Returns Holding Period Return: HPR = Profit Cost HPR =Ending price + Distributions - Beginning price Beginning price HPR= Ending price + Distributions - 1 Beginning price

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Return Example Joe bought some gold coins for \$1000 and sold them 4 months later for \$1200. Jane bought 100 shares of a stock for \$10 and sold them 2 years later for \$12 per share after receiving \$0.50 per share in dividends. Calculate the dollar profit and percent return earned by each investor over his or her respective holding period.
Return Solution??? Joe’s Dollar Profit = Ending value – Original cost = \$1200 - \$1000 = \$200 Joe’s HPR = Dollar profit/Original cost = \$200/\$1000 = 20% Jane’s Dollar Profit = Ending value + Distributions- Original Cost = \$12*100 + \$0.50*100 - \$10*100 = \$1200 + \$50 - \$1000 = \$250 Jane’s HPR = \$250/\$1000 = 25%

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But How Should We Compare? Given Joe’s HPR of 20% over 4 months and Jane’s HPR of 25% over 2 years, is it correct to conclude that Jane’s investment performance was better than Joe’s? Compute each investor’s APR and EAR and then make the comparison.
EAR Formula 1 m m APR 1 EAR - + = Remember that the APR is the quoted rate and m is the number of compounds per year. APR/ m is the period rate.

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So Who Earned More?
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