Ch_13_BLACKBOARD

# Ch_13_BLACKBOARD - Chapter 13 Return Risk and the Security...

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Chapter McGraw-Hill/Irwin 13 Return, Risk, and the Security Market Line

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13-2 Key Concepts and Skills Know how to calculate expected returns Understand the impact of diversification Understand the risk-return trade-off Understand the security market line Be able to use the Capital Asset Pricing Model
13-3 Expected Returns Expected returns are based on the probabilities of possible outcomes In this context, “expected” means average if the process is repeated many times = = n i i i R p R E 1 ) (

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13-4 Example: Expected Returns Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom 0.3 15 25 Normal 0.5 10 20 Recession 0.2 2 1 R C = .3(15) + .5(10) + .2(2) = 9.99% R T = .3(25) + .5(20) + .2(1) = 17.7%
13-5 Variance and Standard Deviation Variance and standard deviation still measure the volatility of returns Using unequal probabilities for the entire range of possibilities Weighted average of squared deviations = - = n i i i R E R p 1 2 2 )) ( ( σ

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13-6 Example: Variance and Standard Deviation Consider the previous example. What are the variance and standard deviation for each stock? Stock C 2200 σ 2 = .3(15-9.9) 2 + .5(10-9.9) 2 + .2(2-9.9) 2 = 20.29 2200 σ = 4.5 Stock T 2200 σ 2 = .3(25-17.7) 2 + .5(20-17.7) 2 + .2(1-17.7) 2 = 74.41 2200 σ = 8.63
13-7 Another Example Consider the following information: State Probability ABC, Inc. (%) Boom .25 15 Normal .50 8 Slowdown .15 4 Recession .10 -3 What is the expected return? E(R) = .25(15) + .5(8) + .15(4) + .1(-3) = 8.05% What is the variance? Variance = .25(15-8.05) 2 + .5(8-8.05) 2 + .15(4-8.05) 2 + .1(-3- 8.05) 2 = 26.7475 What is the standard deviation? Standard Deviation = 5.1717985%

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13-8 Portfolios A portfolio is a collection of assets An asset’s risk and return are important in how they affect the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets
13-9 Why Portfolios? The power of portfolios: State Pro. Ice Cream Umbrella Portfolio (50:50) Sun .50 5% 3% 4% Rain .50 3% 5% 4% E(R) 4% 4% 4% Std. Dev. 1% 1% ? The limitation of portfolios: State Pro. Ice Cream-A Ice Cream-B Portfolio (50:50) Sun .50 5% 5% 5% Rain .50 3% 3% 3% E(R) 4% 4% 4% Std. Dev. 1% 1% ?

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Example: Portfolio Weights Suppose you have \$15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? \$2000 of DCLK
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## This note was uploaded on 04/08/2011 for the course FINANCE 301 taught by Professor Jimmokim during the Spring '11 term at Rutgers.

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Ch_13_BLACKBOARD - Chapter 13 Return Risk and the Security...

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