Topic 5 Risk &amp; Return Part 1

# Topic 5 Risk &amp; Return Part 1 - Topic 5 Risk and...

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Topic 5 Risk and Return – part 1

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Rates of return Historical return The return that an asset has already produced has already produced over a specified period of time Expected return The return that an asset is expected to produce expected to produce over some future future period of time Required return The return that an investor requires an asset requires an asset to produce to produce if he/she is to be a future investor in that asset
Dollar returns The gain (or loss) from an investment. Made up of two components: income, eg dividends, interest payments, capital gain (or loss). Total dollar return = dividend income + capital gain (or loss). Percentage returns                              Dividends paid at Change in market end of period + value over period Percentage return = Beginning market value

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Percentage return example P 0 = \$37.00 P 1 = \$40.33 D 1 = \$1.85 ( 29 14% or 0.14 \$37.00 \$37.00 - \$40.33 \$1.85 Return % = + = Per dollar invested we get 5% in dividends (\$1.85/\$37) and 9% in capital gains (\$3.33/\$37) - a total return of 14%.
State of economy Recession Normal Boom Probability P 0.20 0.50 0.30 Return A B 4% 8% 14% -10% -10% 18% 18% 30% 30% Expected return R is just a weighted average R = P(R 1 ) x R 1 + P(R 2 ) x R 2 + … + P(R n ) x R n Calculating expected returns

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State of economy Recession Recession Normal Normal Boom Boom Probability P 0.20 0.20 0.50 0.50 0.30 0.30 Return A B 4% 4% 8% 8% 14% 14% -10% 18% 30% Company A R = P(R 1 ) x R 1 + P(R 2 ) x R 2 + … + P(R n ) x R n R A = 0.2 x 4% + 0.5 x 8% + 0.3 x 14% = 9% Case study
State of economy Recession Normal Boom Probability P 0.20 0.50 0.30 Return A B 4% 8% 14% - -10% 18% 30% Company B Company B R = P(R 1 ) x R 1 + P(R 2 ) x R 2 + … + P(R n ) x R n R B = 0.2 x -10% + 0.5 x 18% + 0.3 x 30% = 16% Case study

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Risk How to measure risk Variance, standard deviation, beta How to reduce risk Diversification How to price risk Security market line, CAPM
For a Treasury security, what is the required rate of return? For  a  Treasury  security,  what  is  the  required  rate of return? Risky  assets  on  average  earn  a  risk  premium,  ie there is a reward for bearing risk. Required rate of return = = Risk-free Risk-free rate of rate of return return Reason Reason : : Treasury securities are free of default risk Treasury securities are free of default risk

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Required Required rate of rate of return return = = Risk-free Risk-free rate of rate of return return How large a risk premium should we require to How large a risk premium should we require to buy a corporate security? buy a corporate security? + + Risk Risk premium premium For a company security, what is the required rate of return?
What is investment risk? Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return different from that expected. The greater the chance of a return far different from the expected return, the greater the risk.

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0 0.05 0.1 0.15 0.2 -10 -5 0 5 10 15 20 25 30 return return (%) (%) Company Company 2 2 Company Company 1 1 0 0.1 0.2 0.3 0.4 0.5 4 8 12 return return (%) (%) Uncertainty in the distribution of possible outcomes 0 0.1 4 9 12 0 0.05 0.1 0.15 0.2 -10 -3 4 11 16 19 22 25 30 return return (%) (%)

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