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Class 14&15

Class 14&15 - RiskandReturn ,governments fordoings

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Risk and Return Portfolio Theory and CAPM
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Role of Financial Markets Financial markets allow companies, governments  and individuals to increase their utility Savers have the ability to invest in financial assets so that they  can defer consumption and earn a return to compensate them  for doing so Borrowers have better access to the capital that is available so  that they can invest in productive assets Financial markets also provide us with information  about the returns that are required for various  levels of risk
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Why care about returns in financial  markets? To see how our investment is doing But, more importantly as a financial  manager… …we can examine returns in financial markets to  help us determine the appropriate returns on  non-financial assets  they provide a great benchmark as for what we  could have earned instead of taking on an  investment
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What is risk?
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Risk-Return Trade-off Capital Market History shows that there is  reward for bearing risk The greater the potential reward, the greater  is the risk
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History of Returns
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Average Returns over 97-07 Investment Average Return Large Stocks 12.3% Small Stocks 17.1% Long-term Corporate Bonds 6.2% Long-term Government Bonds 5.8% U.S. Treasury Bills 3.8% Inflation 3.1%
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Risk Premium The “extra” return earned for taking on risk Treasury bills are considered to be risk-free Risk premium is the return over and above  the risk-free rate Risk premium is how much you earn over  and above treasury bill rates
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Risk Premiums over 97-07 Investment Average  Return Risk  Premium Large Stocks 12.3% 8.5% Small Stocks 17.1% 13.3% Long-term Corporate Bonds 6.2% 2.4% Long-term Government Bonds 5.8% 2.0% U.S. Treasury Bills 3.8% 0.0%
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Measuring Risk (Ex-ante) Variance and standard deviation measure the  volatility of asset returns The greater the volatility, the greater the  uncertainty, the greater the risk Historical variance:   Sum of squared deviations from the mean / (n – 1) Standard deviation:  Square root of the variance
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Example – Variance and Std. Dev. Variance = .0045 / (4-1) = .0015      Standard Deviation = .03873 Year Actual  Return Average  Return Deviation from  the Mean Squared  Deviation 1 .15 .105 .045 .002025 2 .09 .105 -.015 .000225 3 .06 .105 -.045 .002025 4 .12 .105 .015 .000225 Total .0045
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What matters more is what we expect  to get in returns and risk  (Ex-post)  Expected returns are based on the  probabilities of possible outcomes The “expected” return does not even have to  be a possible return = = n i i i R p R E 1 ) (
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Expected Volatility of Returns 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
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