361-CH8Concise - 8-1CHAPTER 8 Risk and Rates of...

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Unformatted text preview: 8-1CHAPTER 8: Risk and Rates of ReturnUpdated: January 23, 2012 All Financial Assets Produce CFsRisk of Asset Depends on Risk of CFsStand-alone Risk of Asset’s CFsPortfolio Risk of CFsDiversifiable and Market RiskRisk & return: CAPM / SML8-2Investment 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%.8-3What is investment risk?Two types of investment riskStand-alone 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 deviation8-4Probability distributionsA listing of all possible outcomes, and the probability of each occurrence.Can be shown graphically.Expected Rate of ReturnRate ofReturn (%)10015-70Firm XFirm Y8-5Selected Realized Returns, 1926 – 2004 Average Standard Return DeviationSmall-company stocks17.5%33.1%Large-company stocks12.420.3L-T corporate bonds 6.2 8.6L-T 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), p28.8-6Investment alternativesEconomyProb.T-BillHTCollUSRMKT.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%8-7Why 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.8-8How do the returns of HT and Coll. behave in relation to the market?...
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361-CH8Concise - 8-1CHAPTER 8 Risk and Rates of...

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