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Unformatted text preview: 81CHAPTER 8: Risk and Rates of ReturnUpdated: January 23, 2012 All Financial Assets Produce CFsRisk of Asset Depends on Risk of CFsStandalone Risk of Asset’s CFsPortfolio Risk of CFsDiversifiable and Market RiskRisk & return: CAPM / SML82Investment 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%.83What is investment risk?Two types of investment riskStandalone riskPortfolio 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. Risk = Dispersion of Returns around mean, or expected mean: variance or standard deviation84Probability distributionsA listing of all possible outcomes, and the probability of each occurrence.Can be shown graphically.Expected Rate of ReturnRate ofReturn (%)1001570Firm XFirm Y85Selected Realized Returns, 1926 – 2004 Average Standard Return DeviationSmallcompany stocks17.5%33.1%Largecompany stocks12.420.3LT corporate bonds 6.2 8.6LT government bonds 5.8 9.3U.S. Treasury bills 3.8 3.1Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28.86Investment alternativesEconomyProb.TBillHTCollUSRMKT.Recession0.15.5%27.0%27.0% 6.0%17.0%Below avg0.25.5%7.0%13.0%14.0%3.0%Average0.45.5%15.0%0.0%3.0%10.0%Above avg0.25.5%30.0%11.0%41.0%25.0%Boom0.15.5%45.0%21.0%26.0%38.0%87Why is the Tbill return independent of the economy? Do Tbills promise a completely riskfree return?Tbills will return the promised 5.5%, regardless of the economy.No, Tbills do not provide a completely riskfree return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time.Tbills are also risky in terms of reinvestment rate risk.Tbills are riskfree in the default sense of the word.88How do the returns of HT and Coll. behave in relation to the market?...
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This note was uploaded on 01/23/2012 for the course BUS 361 taught by Professor Staff during the Fall '11 term at University of Michigan.
 Fall '11
 STAFF

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