risk&ret

risk&ret - The Investment Principle: Risk and...

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Aswath Damodaran 64 The Investment Principle: Risk and Return Models You cannot swing upon a rope that is attached only to your own belt.
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Aswath Damodaran 65 First Principles
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Aswath Damodaran 66 The notion of a benchmark Since Fnancial resources are Fnite, there is a hurdle that projects have to cross before being deemed acceptable. This hurdle will be higher for riskier projects than for safer projects. A simple representation of the hurdle rate is as follows: Hurdle rate = Riskless Rate + Risk Premium The two basic questions that every risk and return model in Fnance tries to answer are: How do you measure risk? How do you translate this risk measure into a risk premium?
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Aswath Damodaran 67 What is Risk? Risk, in traditional terms, is viewed as a negative . Webster s dictionary, for instance, deFnes risk as exposing to danger or hazard . The Chinese symbols for risk, reproduced below, give a much better description of risk 危機 The Frst symbol is the symbol for danger , while the second is the symbol for opportunity , making risk a mix of danger and opportunity. You cannot have one, without the other.
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Aswath Damodaran 68 A good risk and return model should… 1. It should come up with a measure of risk that applies to all assets and not be asset-speciFc. 2. It should clearly delineate what types of risk are rewarded and what are not, and provide a rationale for the delineation. 3. It should come up with standardized risk measures , i.e., an investor presented with a risk measure for an individual asset should be able to draw conclusions about whether the asset is above-average or below-average risk. 4. It should translate the measure of risk into a rate of return that the investor should demand as compensation for bearing the risk. 5. It should work well not only at explaining past returns , but also in predicting future expected returns.
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Aswath Damodaran 69 The Capital Asset Pricing Model Uses variance of actual returns around an expected return as a measure of risk. SpeciFes that a portion of variance can be diversiFed away, and that is only the non-diversiFable portion that is rewarded. Measures the non-diversiFable risk with beta, which is standardized around one. Translates beta into expected return - Expected Return = Riskfree rate + Beta * Risk Premium Works as well as the next best alternative in most cases.
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Aswath Damodaran 70 The Mean-Variance Framework The variance on any investment measures the disparity between actual and expected returns. Expected Return Low Variance Investment High Variance Investment
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Aswath Damodaran 71 How risky is Disney? A look at the past…
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Aswath Damodaran 72 Do you live in a mean-variance world? Assume that you had to pick between two investments. They have the same
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risk&ret - The Investment Principle: Risk and...

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