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Unformatted text preview: 81CHAPTER 8Risk and Rates of ReturnThis chapter is relatively important.82Investment returnsThe rate of return on an investment can be calculated as follows:(Amount received Amount invested)Return = ________________________ Amount investedFor 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%.83What is investment 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. The greater the range of possible events that can occur, the greater the riskThe Chinese definitionTwo types of investment riskStandalone risk (when the return is analyzed in isolation.)Portfolio risk (when the return is analyzed in a portfolio.)84PART I: Standard alone riskThe risk an investor would face if s/he held only one asset.85Investor attitude towards riskRisk aversion assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities.Who wants to be a millionaire?Risk premium the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities.86Selected Realized Returns, 1926 2001 Average Standard Return DeviationSmallcompany stocks17.3%33.2%Largecompany stocks12.720.2LT corporate bonds 6.1 8.6LT government bonds 5.7 9.4U.S. Treasury bills 3.9 3.2Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.87The Value of an Investment of $1 in 1926Source: Ibbotson Associates0.11010001925 1940 1955 1970 1985 2000S&PSmall CapCorp BondsLong BondT BillIndexYear End16402258764.148.916.688Rates of Return 19262000Source: Ibbotson Associates604020204060263354455556657758859952Common StocksLong TBondsTBillsYearPercentage Return89Suppose there are 5 possible outcomes over the investment horizon for the following securities:EconomyProb.TBillHTCollUSRMPRecession0.15.5%27.0%27.0% 6.0%17.0%Below avg0.25.5%7.0%13.0%14.0%3.0%Average0.45.5%15.0%0.0%3.0%10.0%Above avg0.25.5%30.0%11.0%41.0%25.0%Boom0.15.5%45.0%21.0%26.0%38.0%810Why is the Tbill return independent of the economy? Tbills will return the promised 5.5%, regardless of the economy....
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 Spring '07
 Chen
 Forex

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