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Unformatted text preview: Ch 6: Risk and Ch 6: Risk and Rates of Return Rates of Return Return Return Risk Risk In Chapter 6 we examine RISK In Chapter 6 we examine RISK How to measure risk (variance, standard deviation, beta) How to reduce risk (diversification) How to price risk (security market line, CAPM) Required Required rate of rate of return return = = Riskfree Riskfree rate of rate of return return For a Treasury security, what is For a Treasury security, what is the required rate of return? the required rate of return? Since Treasurys are essentially free of default risk, the rate of return on a Treasury security is considered the riskfree rate of return. Required Required rate of rate of return return = = Riskfree Riskfree rate of rate of return return + + Risk Risk Premium Premium For a corporate stock or bond, what is For a corporate stock or bond, what is the required rate of return? the required rate of return? How large of a risk premium should we require to buy a corporate security? RETURN RETURN Required Return the return that an investor requires on an asset given its risk . Expected Return Expected Return State of Probability Return Economy (P) Utility HiTech Recession .20 4% 10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average : k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn Expected Return Expected Return State of Probability Return Economy (P) Utility HiTech Recession .20 4% 10% Normal .50 10% 14% Boom .30 14% 30% k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (util.) = .2 (4%) + .5 (10%) + .3 (14%) = 10% Expected Return Expected Return State of Probability Return Economy (P) Utility HiTech Recession .20 4% 10% Normal .50 10% 14% Boom .30 14% 30% k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (HT) =.2 (10%)+ .5 (14%) + .3 (30%) = 14% Based only on your expected return calculations, which stock would you prefer? What is Risk? What is Risk? The possibility that an actual return will differ from our expected return. Uncertainty in the distribution of possible outcomes. What is Risk? What is Risk? Uncertainty in the distribution of possible outcomes. 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2105 5 10 15 20 25 30 Company B return 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 4 8 12 Company A return How do we Measure Risk? How do we Measure Risk? The standard approach is to examine the stocks STANDARD DEVIATION of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK. Standard Deviation Standard Deviation n i =1 = (k i k) P(k i ) 2 Utility, Inc....
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 Fall '11
 McGregor

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