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Chapter 08 - CHAPTER8 Standalonerisk Portfoliorisk...

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    8-1 CHAPTER 8 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML
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    8-2 Investment returns The rate of return on an investment can be  calculated as follows: (Amount received – Amount invested) Return =       ________________________                                                    Amount invested For 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%.
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    8-3 What is investment risk? Two types of investment risk Stand-alone risk Portfolio 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.
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    8-4 Probability distributions A listing of all possible outcomes, and the  probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y
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    8-5 Selected Realized Returns,  1926 – 2004       Average    Standard        Return      Deviation Small-company stocks 17.5% 33.1% Large-company stocks 12.4 20.3 L-T corporate bonds  6.2  8.6 L-T government bonds   5.8  9.3 U.S. Treasury bills  3.8  3.1 Source:  Based on  Stocks, Bonds, Bills, and Inflation:  (Valuation  Edition) 2005 Yearbook  (Chicago:  Ibbotson Associates, 2005), p28.
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    8-6 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%
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    8-7 Why is the T-bill return independent of  the economy?  Do T-bills promise a  completely risk-free return? T-bills will return the promised 5.5%, regardless  of the economy. 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. T-bills are also risky in terms of reinvestment rate  risk. T-bills are risk-free in the default sense of the  word.
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    8-8 How do the returns of HT and Coll.  behave in relation to the market? HT – Moves with the economy, and has  a positive correlation.  This is typical. Coll. – Is countercyclical with the  economy, and has a negative  correlation.  This is unusual.
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    8-9 Calculating the expected return   12.4%     (0.1)   (45%)              (0.2)   (30%)     (0.4)   (15%)           (0.2)   (-7%)     (0.1)   (-27%)     r P   r       r         return   of   rate    expected     r HT ^ N 1 i i i ^ ^ = + + + + = = = =
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    8-10 Summary of expected returns      Expected return HT    12.4% Market    10.5% USR     9.8% T-bill     5.5% Coll.     1.0%
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