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ch 08 - Chapter8 StandAloneRisk PortfolioRisk...

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Risk and Rates of Return Chapter 8 Stand-Alone Risk Portfolio Risk Risk and Return:  CAPM/SML 8-1
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Investment Returns The rate of return on an investment can be  calculated as follows: For 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%. 8-2 ( 29 Cost Cost    value ending   Expected   Return - =
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What is investment risk? Two types of investment risk Stand-alone risk Portfolio 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. 8-3
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Probability Distributions A listing of all possible outcomes, and the  probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y 8-4
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Selected Realized Returns, 1926-2007       Average    Standard        Return      Deviation Small-company stocks 17.1% 32.6% Large-company stocks 12.3 20.0 L-T corporate bonds  6.2  8.4 L-T government bonds   5.8  9.2 U.S. Treasury bills  3.8  3.1 Source:  Based on  Stocks, Bonds, Bills, and Inflation:  (Valuation  Edition) 2008 Yearbook  (Chicago:  Morningstar, Inc., 2008), p28. 8-5
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Investment Alternatives Economy Prob. T-Bill HT Coll USR MP Recession 0.1 5.5% -27.0% 27.0%   6.0% -17.0% Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0% Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0% Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0% Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0% 8-6
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Why 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. 8-7
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How do the returns of HT and Coll. behave  in relation to the market? HT – Moves with the economy, and has a  positive correlation.  This is typical. Coll. – Is countercyclical with the economy,  and has a negative correlation.  This is  unusual. 8-8
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Calculating the Expected Return 8-9 12.4% (45%)(0.1) (30%)(0.2)         ) 4 . 0 %)( 15 ( ) 2 . 0 %)( 7 - ( ) 1 . 0 %)( 27 - ( r ˆ P r r ˆ return   of   rate   xpected E   r ˆ N 1 i i i = + + + + = = = =
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Summary of Expected Returns      Expected return HT    12.4% Market    10.5% USR     9.8% T-bill     5.5% Coll.     1.0% HT has the highest expected return, and  appears to be the best investment alternative,  but is it really?  Have we failed to account for  risk?
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