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Unformatted text preview: 51CHAPTER 8Risk and Rates of ReturnStandalone riskPortfolio riskRisk & return: CAPM / SML52Investment 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%.53What is investment risk?Two types of investment riskStandalone 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.54What 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.55Probability distributionsA listing of all possible outcomes, and the probability of each occurrence.Can be shown graphically.Expected Rate of ReturnRate ofReturn (%)1001570Firm XFirm Y56Selected Realized Returns, 1926 – 2007 19262001 19262007 Average Standard Average Standard Return Deviation Return DeviationSmallcompany stocks17.3%33.2%17.1% 32.6%Largecompany stocks12.720.212.3%20.0%LT corporate bonds 6.1 8.66.2%8.4%LT 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).57Investment alternativesEconomyProb.TBillHTCollUSRMPRecession0.18.0%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%58Why is the Tbill return independent of the economy? Do Tbills promise a completely riskfree return?...
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 Spring '07
 Chen
 Finance, Forex, ht

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