311 ch6 - Risk and Return Chapter 6 Outline Definition and...

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Risk and Return Chapter 6
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Outline Definition and Measurement of Risk Relationship between Risk and Return Diversification and Risk Portfolio Risk Capital Asset Pricing Model
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Risk is the possibility that actual cash flows (or returns) will be different than expected cash flows (or returns) An investment is risk-free only if the cash flows (returns) are known with certainty US Treasury bills (i.e., short-term) Risky investments have uncertain payoffs (i.e., are variable) Riskiness is measured in terms of the variability of the returns Risk
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Expected Value Expected Value is a statistical measure of the most likely outcome Probability weighted average = = n j j j p r r 1 ˆ r j p j r j p j 10% 0.2 2% 18% 0.6 10.8% 26% 0.2 5.2% Σ =18%
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Standard Deviation Measure of Risk How far is each outcome from the expected value? Square deviations so positive and negative deviations don’t cancel each other out Weight by probabilities Take square root so it is measured in same units ( 29 = - = n j j j p r r 1 2 ˆ σ
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0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 0.045 -100 -50 0 50 100 Outcome Probability Series1 Series2 What is the expected value? Which has the higher standard deviation?
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Normal Probability Distribution Normal distribution is the ‘Bell-shaped curve’ Normal distribution can be described entirely by its mean and standard deviation Z score Approximately two-thirds (68.26%) of outcomes are within one standard deviation of the mean. 95.44% of outcomes are within 2 standard deviations and 99.74% are within 3 standard deviations You can find probabilities of any z by using Table V σ r r ˆ - = z
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Coefficient of Variation Sometimes, standard deviation is too absolute a measure of risk Consider two projects – both have payoffs with a standard deviation of $1,000. Project A has an expected payoff of $10,000 while Project B
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311 ch6 - Risk and Return Chapter 6 Outline Definition and...

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