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FM12e_Ch 06_R&amp;RBasics

# FM12e_Ch 06_R&amp;RBasics - CHAPTER6 Risk,Return,and 1...

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1 CHAPTER 6 Risk, Return, and  the Capital Asset Pricing Model

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2 Topics in Chapter Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML
3 What are investment returns? Investment returns measure the  financial results of an investment. Returns may be historical or prospective  (anticipated). Returns can be expressed in: Dollar terms. Percentage terms.

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4 An investment costs \$1,000 and is  sold after 1 year for \$1,100. Dollar return: Percentage return: \$ Received - \$ Invested \$1,100 - \$1,000 = \$100. \$ Return/\$ Invested \$100/\$1,000 = 0.10 = 10%.
5 What is investment risk? Typically, investment returns are not  known with certainty. Investment risk pertains to the  probability of earning a return less than  that expected. The greater the chance of a return far  below the expected return, the greater  the risk.

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6 Probability Distribution: Which  stock is riskier?  Why? -30 -15 0 15 30 45 60 Returns (% ) Stock A Stock B
7 Consider the Following Investment Alternatives Econ. Prob. T-Bill Alta Repo Am F. MP Bust  0.10 8.0% -22.0%  28.0%  10.0% -13.0% Below  avg.  0.20  8.0  -2.0  14.7 -10.0    1.0 Avg.  0.40  8.0  20.0    0.0    7.0  15.0 Above  avg.  0.20  8.0  35.0 -10.0  45.0  29.0 Boom  0.10  8.0  50.0 -20.0  30.0  43.0  1.00

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8 What is unique about the T-bill  return? The T-bill will return 8% regardless of  the state of the economy. Is the T-bill riskless?  Explain.
9 Alta Inds. and Repo Men vs.  the Economy Alta Inds. moves with the economy, so it  is positively correlated with the  economy.  This is the typical situation. Repo Men moves counter to the  economy.  Such negative correlation is  unusual.

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10 Calculate the expected rate of  return on each alternative. r = expected rate of return. r Alta = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%. ^ ^ n r = ^ i=1 r i P i .
11 Alta has the highest rate of  return. Does that make it best? ^ r Alta 17.4% Market 15.0 Am. Foam 13.8 T-bill   8.0 Repo Men   1.7

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12 What is the standard deviation of returns for each alternative? σ = Standard deviation σ = √ Variance = √ σ 2 n i=1 = (r i – r) 2 P i . ^
13 σ = [(-22 - 17.4) 2 0.10 + (-2 - 17.4) 2 0.20 + (20 - 17.4) 2 0.40 + (35 - 17.4) 2 0.20 + (50 - 17.4) 2 0.10] 1/2 = 20.0%. Standard Deviation of Alta  Industries

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14 σ T-bills = 0.0%. σ Alta = 20.0%. σ Repo = 13.4%. σ Am Foam = 18.8%. σ Market = 15.3%. Standard Deviation of  Alternatives
15 Stand-Alone Risk Standard deviation measures the stand- alone risk of an investment. The larger the standard deviation, the  higher  the probability that  returns will  be far below the expected return.

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16 Expected Return versus Risk Security Expected return Risk,  σ Alta Inds.    17.4%  20.0% Market    15.0  15.3 Am. Foam    13.8  18.8 T-bills      8.0    0.0 Repo Men                    1.7  13.4
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FM12e_Ch 06_R&amp;RBasics - CHAPTER6 Risk,Return,and 1...

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