05-Risk-returns-FIN6406 - Risk and Return Risk and Return...

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Unformatted text preview: Risk and Return Risk and Return 11 Risk and Return n Stand-alone risk n Portfolio risk n Risk and return: CAPM/SML n Changes in inflation & risk aversion Risk and Return Risk and Return 22 What is investment risk? n Investment risk pertains to the probability of earning less than the expected return. n The greater the chance of low or negative returns, the riskier the investment. Risk and Return Risk and Return 33 Probability distribution Expected Rate of Return Rate of return (%) 10 15- 70 Firm X Firm Y Risk and Return Risk and Return 44 Investment Alternatives (Table shows returns under different economic states.) 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 1.0 Risk and Return Risk and Return 55 Why is the T-bill return independent of the economy? T-bills will return the promised 8%, regardless of the state of the economy. Risk and Return Risk and Return 66 Do T-bills promise a completely risk-free return? n No n T-bills are still exposed to the risk of unexpected inflation. n However, not much unexpected inflation is likely to occur over a relatively short period. Risk and Return Risk and Return 77 Do the returns of High Tech and Collections move with or counter to the economy? n HT : With. Positive correlation . Typical. n Coll : Countercyclical. Negative correlation . Unusual. Risk and Return Risk and Return 88 R = Ri Pi Calculate the expected rate of return on each alternative R = Expected rate of return RHT = (-22%)0.10 + (-2%)0.20 + (20%)0.40 + (35%)0.20 + (50%)0.10 = 17.4% . ^ ^ ^ i = 1 n Risk and Return Risk and Return 99 HT appears to be the best, but is it really? ^ R HT 17.4% Market 15.0 USR 13.8 T-bill 8.0 Coll. 1.7 Risk and Return Risk and Return 1010 Whats the standard deviation of returns for each alternative? = standard deviation Risk and Return Risk and Return 1111 T-bills = 0.0%. HT = 20.0%. Coll= 13.4%. USR = 18.8%. M= 15.3%. 1/ 2 ( 29 ( 29 ( 29 ( 29 ( 29 T-bills = 8.0 - 8.0 + 8.0 - 8.0 8.0 - 8.0 + 8.0 - 8.0 2 2 2 2 2 0 1 0 2 0 4 0 2 8 0 - 8 0 0 1 . ....
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05-Risk-returns-FIN6406 - Risk and Return Risk and Return...

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