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Unformatted text preview: Click to edit Master title style 12/29/11 1 12/29/11 Chapter 13 Return, Risk, and the Security Market Line Click to edit Master title style 12/29/11 2 12/29/11 Key Concepts and Skills • Know how to calculate expected returns • Understand the impact of diversification • Understand the systematic risk principle • Understand the security market line • Understand the riskreturn tradeoff • Be able to use the Capital Asset Pricing Model Click to edit Master title style 12/29/11 3 12/29/11 Expected Returns • Expected returns are based on the probabilities of possible outcomes • In this context, “expected” means average if the process is repeated many times • The “expected” return does not even have to be a possible return ∑ = = n i i i R p R E 1 ) ( Click to edit Master title style 12/29/11 4 12/29/11 Example: Expected Returns • Suppose you have predicted the following returns for stocks C and T in three possible states of the economy. What are the expected returns? State Probability C T Boom 0.3 15 25 Normal 0.5 10 20 Recession ??? 2 1 • R C = .3(15) + .5(10) + .2(2) = 9.9% • R T = .3(25) + .5(20) + .2(1) = 17.7% What is the probability of a recession? 0.2 If the riskfree rate is 4.15%, what is the risk premium? Stock C: 9.9 – 4.15 = 5.75% Stock T: 17.7 – 4.15 = 13.55% Click to edit Master title style 12/29/11 5 12/29/11 Variance and Standard Deviation • Variance and standard deviation measure the volatility of returns • Using unequal probabilities for the entire range of possibilities • Weighted average of squared deviations ∑ = = n i i i R E R p 1 2 2 )) ( ( σ Click to edit Master title style 12/29/11 6 12/29/11 Example: Variance and Standard Deviation • Consider the previous example. What are the variance and standard deviation for each stock? • Stock C • σ 2 = .3(159.9) 2 + .5(109.9) 2 + .2(29.9) 2 = 0.2029% • σ = 4.50% • Stock T • σ 2 = .3(2517.7) 2 + .5(2017.7) 2 + .2(117.7) 2 = 74.41 • σ = 8.63% Click to edit Master title style 12/29/11 7 12/29/11 Another Example • Consider the following information: State Probability ABC, Inc. (%) Boom .25 15 Normal .50 8 Slowdown .15 4 Recession .103 • What is the expected return? • What is the variance? • What is the standard deviation? E(R) = .25(15) + .5(8) + .15(4) + .1(3) = 8.05% Variance = .25(158.05) 2 + .5(88.05) 2 + . 15(48.05) 2 + .1(38.05) 2 = 26.7475 Click to edit Master title style 12/29/11 8 12/29/11 Portfolios • A portfolio is a collection of assets • An asset’s risk and return are important in how they affect the risk and return of the portfolio • The riskreturn tradeoff for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets Click to edit Master title style 12/29/11 9 12/29/11 Example: Portfolio Weights • Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security?each security?...
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This note was uploaded on 12/28/2011 for the course FI 311 taught by Professor Booth during the Fall '06 term at Michigan State University.
 Fall '06
 Booth

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