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350-07a_note[1]

350-07a_note[1] - 350-07a_note 11S TOPIC 7 RISK AND RATES...

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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 Chapter 8 Question 1, 5, 7, 8 Problem 1, 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: 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) 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 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% T-bill 5.5% Coll. 1.0%