Chapter 8

# Chapter 8 - 5-1CHAPTER 8Risk and Rates of ReturnStand-alone...

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Unformatted text preview: 5-1CHAPTER 8Risk and Rates of ReturnStand-alone riskPortfolio riskRisk & return: CAPM / SML5-2Investment 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%.5-3What is investment risk?Two types of investment riskStand-alone riskPortfolio risk Downside Risk: The Investment Risk that is more relevant for investors:Investment risk is related to the probability of earning a low or negative actual return (Note: this is more of a downside risk concept).The greater the chance of lower than expected or negative returns, the riskier the investment.5-4What is investment risk?Academic Concept of Investment Risk:Risk in this context is defined as the uncertainty of potential outcomes for an investment.If all the potential outcomes for this investment are known, but each outcome is defined by a probability, then the expected (average) outcome and its risk can be computed, especially when the outcomes are normally distributed.5-5Probability distributionsA listing of all possible outcomes, and the probability of each occurrence.Can be shown graphically.Expected Rate of ReturnRate ofReturn (%)10015-70Firm XFirm Y5-6Selected Realized Returns, 1926 – 2007 1926-2001 1926-2007 Average Standard Average Standard Return Deviation Return DeviationSmall-company stocks17.3%33.2%17.1% 32.6%Large-company stocks12.720.212.3%20.0%L-T corporate bonds 6.1 8.66.2%8.4%L-T government bonds 5.7 9.45.8%9.2%U.S. Treasury bills 3.9 3.23.8%3.1%Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2008 Yearbook (Chicago: Ibbotson Associates, 2008).5-7Investment alternativesEconomyProb.T-BillHTCollUSRMPRecession0.18.0%-22.0%28.0%10.0%-13.0%Below avg0.28.0%-2.0%14.7%-10.0%1.0%Average0.48.0%20.0%0.0%7.0%15.0%Above avg0.28.0%35.0%-10.0%45.0%29.0%Boom0.18.0%50.0%-20.0%30.0%43.0%5-8Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return?...
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## This note was uploaded on 11/11/2011 for the course FIN 350 taught by Professor Chen during the Spring '07 term at S.F. State.

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Chapter 8 - 5-1CHAPTER 8Risk and Rates of ReturnStand-alone...

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