ch05_v1_060305 - CHAPTER5 Standalonerisk Portfoliorisk...

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    5-1 CHAPTER 5 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML
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    5-2 Investment returns The rate of return on an investment can be  calculated as follows: (Amount received – Amount invested) Return =       ________________________                                                    Amount invested For example, if $1,000 is invested and $1,100 is  returned after one year, the rate of return for this  investment is:  ($1,100 - $1,000) / $1,000 = 10%.
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    5-3 What is investment risk? Two types of investment risk Stand-alone risk Portfolio risk  Investment risk is related to the probability  of earning a low or negative actual return. The greater the chance of lower than  expected or negative returns, the riskier the  investment.
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    5-4 Probability distributions A listing of all possible outcomes, and the  probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y
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    5-5 Selected Realized Returns,  1926 – 2001       Average    Standard        Return      Deviation Small-company stocks 17.3% 33.2% Large-company stocks 12.7 20.2 L-T corporate bonds  6.1  8.6 L-T government bonds   5.7  9.4 U.S. Treasury bills  3.9  3.2 Source:  Based on  Stocks, Bonds, Bills, and Inflation:  (Valuation  Edition) 2002 Yearbook  (Chicago:  Ibbotson Associates, 2002), 28.
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    5-6 Investment alternatives Economy Prob. T-Bill HT Coll USR MP Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0% Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0% Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0% Above  avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0% Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%
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    5-7 Why is the T-bill return independent of  the economy?  Do T-bills promise a  completely risk-free return? T-bills will return the promised 8%, regardless of  the economy. No, T-bills do not provide a risk-free return, as  they are still exposed to inflation.  Although, very  little unexpected inflation is likely to occur over  such a short period of time. T-bills are also risky in terms of reinvestment rate  risk. T-bills are risk-free in the default sense of the  word.
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    5-8 How do the returns of HT and Coll.  behave in relation to the market? HT – Moves with the economy, and has  a positive correlation.  This is typical. Coll. – Is countercyclical with the  economy, and has a negative  correlation.  This is unusual.
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    5-9 Return: Calculating the expected  return for each alternative   17.4%     (0.1)   (50%)              (0.2)   (35%)     (0.4)   (20%)           (0.2)   (-2%)     (0.1)   (-22.%)     k P   k       k         return   of   rate   expected     k HT ^ n 1 i i i ^ ^ = + + + + = = = =
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    5-10 Summary of expected returns  for all alternatives Exp return HT    17.4% Market    15.0% USR    13.8% T-bill     8.0%
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