Ch10 & ch11 - Ch10andCh11 Risk and Return 1...

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1 Ch 10 and Ch 11 Risk and Return
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2 Ch 10 and 11 Dollar return and Percentage Return Measuring Return and Risk Historical returns and risk Expected returns and risk Capital market history Understanding Risk Systematic risk vs. Unsystematic risk Diversification Capital Asset pricing Model (CAPM) Security Market Line (SML) Beta Stock Market Efficiency
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3
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4 Return : Capital Market History  Dollars $10,000 $1,000 $100 $10 $1 $0.1 1925 1935 1945 1955 1965 1975 Year-end 1985 1995 1999 Small-company stocks Large-company stocks Inflation Treasury bills Long-term government bonds $6,640.79 $2,845.63 $40.22 $15.64 $9.39
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6 Risk : The Great Bull Market of 1982  – 1999, “Bumps Along the Way” Period % Decline in S&P 500 Oct. 10, 1983 – July 24, 1984 -14.4% Aug. 25, 1987 – Oct. 19, 1987 -33.2% Oct. 21, 1987 – Oct. 26, 1987 -11.9% Nov. 2, 1987 – Dec. 4, 1987 -12.4% Oct. 9, 1989 – Jan. 30, 1990 -10.2% July 16, 1990 – Oct. 11, 1990 -19.9% Feb. 18, 1997 – Apr. 11, 1997 -9.6% July 19, 1999 – Oct. 18, 1999 -12.1%
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7 Calculating returns Dollar return = dividend income + capital gain (or loss) Percentage return = dividend yield + capital gains yield where, dividend yield = dividend income / beginning price capital gains yield = (ending price – beginning price) / beginning price.
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8 Example: $ Return, % Return -$10 $14 $1 $13
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9 Measuring Return and Risk  Historical return and risk Expected return and risk
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10 Historical returns Example: Find the average returns and standard deviation of the stock for given four years data. Assume that at Year 0, the price was $100. Year Actual Return Price 1 15% $115.00 2 9% $125.35 3 -6% $117.83 4 12% $131.97
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11 Historical return and risk Historical average return r = Σ r i / N = (15 + 9 + (-6) + 12 ) / 4 = 30 / 4 = 7.5% ¯
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12 What is investment risk? Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk. Risk = volatility of returns = standard deviation of returns
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13 Standard Deviation: “Rolling a Dice” Suppose Michelle, Jennifer, and Christine play at the Rolling Dice Contest. Each contestant rolls a dice four times. Michelle: 1, 6, 6, 1 Jennifer: 3, 4, 4, 3 Christine: 2, 5, 5, 2 Which contestant’s outcomes shows the highest standard deviation?
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14 Picturing Risk: Frequency distribution  of returns on common stocks 1936 1937 1974 1930 1973 1966 1957 1941 1990 1981 1977 1969 1962 1953 1946 1940 1939 1934 1932 1929 1994 1993 1992 1987 1984 1978 1970 1960 1956 1948 1947 1988 1986 1979 1972 1971 1968 1965 1964 1959 1952 1949 1944 1926 1999 1998 1996 1983 1982 1976 1967 1963 1961 1951 1943 1942 1997 1995 1991 1989 1985 1980 1975 1955 1950 1945 1938 1936 1927 1956 1935 1928 1954 1933 1 1 2 4 12 12 11 13 13 2 3 0 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 Return (%) Risk can be pictured by constructing frequency distribution.  The flatter the distribution is, the greater the risk.
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15 Picturing Risk: Normal Distribution -3 -47.0% -2 -26.9% -1 -6.8% 0 13.3% +1 33.4% +2 53.5% +3 73.6% Probability Return on large common stocks 68% 95% >99% High Risk Low Risk Suppose average return on large common stocks is 13.3%, and standard deviation of returns is 20.1%
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16 Normal Distribution Of all observed values, 68.3 percent will occur within plus/minus one standard deviation of the mean Of all observed values, 95.7 percent will
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