Lecture_9._Risk_and_Return - Lecture 9 The Meaning and...

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Lecture 9 The Meaning and Measurement of Risk and Return Osvaldo Lagares, M.S.
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Slide Contents Principles used in this chapter 1. Expected return 2. Risk Defined and Measured 3. Rates RI 5HWXUQ± 7KH ,QYHVWRU¶V ([SHULHQFH 4. Risk and Diversification 5. The ,QYHVWRU¶V 5HTXLUHG 5DWH RI 5HWXUQ 1
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Principles Applied in this Chapter ± Principle 1 : Risk requires a reward. ± Principle 2 : Cash flow is what matters. 3
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Expected Return Historical or holding-period or realized rate of return: Holding period return = payoff during the ³KROGLQJ´ SHULRG± +ROGLQJ SHULRG FRXOG EH one day, few weeks or few years. 4
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± You bought 1 share of HPD for $19.70 in May 2008 and sold it for $32.32 in May 2009. The company paid divided of 8 cents every quarter during the last two years. ± Holding Period dollar gain, DG = 32.32 + .08*4 ² 19.70 = $12.94 5 Expected Return
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Holding Period rate of return = 12.94/19.70 = .6568 or 65.68% 6 Expected Return
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Expected Cash Flows and Expected Return ± The expected benefits, or returns, an investment generates come in the form of cash flows. ± Cash flows are used to measure returns (not accounting profits). 7 Expected Return
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± The expected cash flow is the weighted average of the possible cash flows outcomes such that the weights are the probabilities of the occurrence of the various states of the economy. ± Expected Cash flow ( X ) = Ȉ Pb i * Cf i Ł Where Pb i = probabilities of outcome i Ł CF i = cash flows in outcome i 8 Expected Return
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Measuring the Expected Cash Flow and Expected Return 9 State of the economy Probability of the states Cash flow from the investment % Return (Cash Flow/Inv. Cost) Economic Recession 20% $1,000 10% ($1,000/$10,000) Moderate Economic Growth 30% 1,200 12% ($1,200/$10,000) Strong Economic Growth 50% 1,400 14% ($1,400/$10,000)
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Expected Cash Flow Equation 10
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Expected Cash Flow ± Expected Cash flow = Ȉ Pb i * CF i = .2*1000 + .3*1200 + .5*1400 = $1,260 on $1,000 investment 11
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Expected Rate of Return ± We can also determine the % expected return on $1,000 investment. Expected Return is the weighted average of all the possible returns, weighted by the probability that each return will occur. ± Expected Return (%) = Ȉ Pb i * r i Ł Where Pb i = probabilities of outcome i Ł r i = expected % return in outcome i 12
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Expected Rate of Return 13
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Expected Rate of Return ± Expected Return (%) = Ȉ Pb i * r i Ł Where P i = probabilities of outcome i Ł k i = expected % return in outcome i = .2(10%) + .3(12%) + .5(14%) = 12.6% 14
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