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Chap013

# Chap013 - Chapter 13 Return Risk and the Security M arket L...

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Chapter 13 Return, Risk, and the Security Market Line

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Key Concepts and Skills Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand the security market line Understand the risk-return trade-off Be able to use the Capital Asset Pricing Model 13-2
Chapter Outline Expected Returns and Variances Portfolios Announcements, Surprises, and Expected Returns Risk: Systematic and Unsystematic Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital: A Preview 13-3

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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 The “expected” return does not even have to be a possible return = = n i i i R p R E 1 ) ( 13-4
Example: Expected Returns Suppose you have predicted the following returns for stocks C and T in three possible states of the economy. What are the expected returns? State Probability C T Boom 0.3 15 25 Normal 0.5 10 20 Recession ??? 2 1 R C = .3(15) + .5(10) + .2(2) = 9.9% R T = .3(25) + .5(20) + .2(1) = 17.7% 13-5

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Variance and Standard Deviation Variance and standard deviation 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 13-6
Example: Variance and Standard Deviation Consider the previous example. What are the variance and standard deviation for each stock? Stock C σ 2 = .3(15-9.9) 2 + .5(10-9.9) 2 + .2(2-9.9) 2 = 20.29 σ = 4.50% Stock T σ 2 = .3(25-17.7) 2 + .5(20-17.7) 2 + .2(1-17.7) 2 = 74.41 σ = 8.63% 13-7

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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? What is the variance? What is the standard deviation? 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

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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?
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