35007a_note, 11S
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TOPIC 7: RISK AND RATES OF RETURN (CHAPTER 8)
I.
Outline
A.
Basics
B.
StandAlone Risk
1.
Riskfree return, correlation, expected return, SD, CV
C.
Portfolio Risk
1.
Market risk Vs. Diversifiable risk
D.
Risk & Return
1.
CAPM (Capital Asset Pricing Model)
2.
SML (Security Market Line)
II.
Homework Assignment
Chapter
8
Question
1, 5, 7, 8
Problem
1, 2, 58, 11, 12, 16, 19
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Class Notes
I.
Basics
A.
Investment Returns
1.
The rate of return on an investment can be calculated as follows:
invested
Amount
Invested
Amount

eived
Amount rec
Return
2.
Example:
$1,000 is invested and $1,100 is returned after one year, the rate of return for this
investment is
Return
B.
Investment Risk
1.
Two types of investment risk
a)
Standalone risk
b)
Portfolio risk
2.
Investment risk is related to the probability of earning a low or negative actual return.
3.
The greater the chance of lower than expected or negative returns, the riskier the investment.
C.
Probability Distributions
1.
A listing of all possible outcomes, and the probability of each occurrence.
2.
Can be shown graphically.
D.
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35007a_note, 11S
Page 2 of 12
II.
StandAlone Risk
A.
Example: Investment Alternatives
Economy
Prob.
TBill
HT
Coll
USR
MP
Recession
0.1
5.5%
27.0%
27.0%
6.0%
17.0%
Below avg
0.2
5.5%
7.0%
13.0%
14.0%
3.0%
Average
0.4
5.5%
15.0%
0.0%
3.0%
10.0%
Above avg
0.2
5.5%
30.0%
11.0%
41.0%
25.0%
Boom
0.1
5.5%
45.0%
21.0%
26.0%
38.0%
B.
Investor attitude towards risk
1.
Risk aversion – assumes investors dislike risk and require higher rates of return to encourage
them to hold riskier securities.
2.
Risk premium – the difference between the return on a risky asset and a riskless asset, which
serves as compensation for investors to hold riskier securities.
C.
RiskFree Rate: Why is the Tbill return independent of the economy?
Do Tbills promise a
completely riskfree return? (Case A1)
1.
Tbills will return the promised 5.5%, regardless of the economy.
2.
No, Tbills do not provide a completely riskfree return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely to occur over such a short period of time.
3.
Tbills are also risky in terms of reinvestment rate risk.
4.
Tbills are riskfree in the default sense of the word.
D.
Correlation: How do the returns of HT and Coll. behave in relation to the market? (Case A2)
1.
HT – Moves with the economy, and has a positive correlation.
This is typical.
2.
Coll. – Is countercyclical with the economy, and has a negative correlation.
This is unusual.
E.
Expected Return (Case B)
1.
Expected return (or estimated return) can be calculated as
N
1
i
Pr
ˆ
i
i
r
r
2.
Example: calculate the expected return for HT.
Economy
Prob.
HT, r
i
i
i
r
*
Pr
Recession
0.1
27.0%
Below avg
0.2
7.0%
0.014
Average
0.4
15.0%
0.06
Above avg
0.2
30.0%
Boom
0.1
45.0%
0.045
ˆ
r
3.
Calculate expected return for other investments
Company
Expected
Return
ˆ
r
Standard
Deviation, SD,
Coefficient of
Variance, CV
Market
Beta,
β
CAPM, r
Action
HT
12.4%
Market
10.5%
USR
9.8%
Tbill
5.5%
Coll.
1.0%