350-07a_note, 11S Page 1 of 12 TOPIC 7: RISK AND RATES OF RETURN (CHAPTER 8) I.Outline A.Basics B.Stand-Alone Risk 1.Risk-free 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 Chapter8Question1, 5, 7, 8Problem1, 2, 5-8, 11, 12, 16, 19================================================================ Class Notes I.Basics A.Investment Returns 1.The rate of return on an investment can be calculated as follows: investedAmount InvestedAmount -eived Amount recReturn2.Example: $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is ReturnB.Investment Risk 1.Two types of investment risk a)Stand-alone 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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350-07a_note, 11S Page 2 of 12 II.Stand-Alone Risk A.Example: Investment Alternatives Economy Prob. T-Bill 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.Risk-Free Rate: Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return? (Case A1) 1.T-bills will return the promised 5.5%, regardless of the economy. 2.No, T-bills do not provide a completely 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. 3.T-bills are also risky in terms of reinvestment rate risk. 4.T-bills are risk-free 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 N1iPrˆiirr2.Example: calculate the expected return for HT. Economy Prob. HT, riiir*PrRecession 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 ˆr3.Calculate expected return for other investments Company Expected Return ˆrStandard Deviation, SD, Coefficient of Variance, CV Market Beta, βCAPM, r Action HT 12.4% Market 10.5% USR 9.8% T-bill 5.5% Coll. 1.0%