review risk and return. r = expected rate of return. ^
TRANSCRIPT
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Review
Risk and Return
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.P = rn
1=iii
r
r = expected rate of return.^
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stand-alone risk
An asset’s risk can be analyzed in two ways:
(1) on a stand-alone basis, where the asset is considered in isolation, and
(2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio.
Thus, an asset’s stand-alone risk is the risk an investor would face if he or she held only this one asset.
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Probability distribution
Rate ofreturn (%) 50150-20
Stock X
Stock Y
Which stock is riskier? Why?
30
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Measuring Stand-Alone Risk: Standard deviation σ
1- Standard deviation σ ( absolute mean of risk)
Standard deviation measures the stand-alone risk of an investment.
The larger the standard deviation, the higher the probability that returns will be far below the expected return.
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Standard deviation σ
.
Variance
deviation Standard
1
2
2
n
iii Prr
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Measuring Stand-Alone Risk: The Coefficient of Variation2- The coefficient of variation CV (an
alternative measure of stand-alone risk.)
CV = σ/ r^ It shows the risk per unit of return It provide a more meaningful basis for
comparison When the expected return on two
alternatives are not the same.
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Portfolio Return, rp̂
^ ^rp = wirin
i = 1
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.
Variance
deviation Standard
1
2
2
n
iipip Prrp
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Two-Stock Portfolios
Two stocks can be combined to form a riskless portfolio if = -1.0.
Risk is not reduced at all if the two stocks have = +1.0.
In general, stocks have 0.65, so risk is lowered but not eliminated.
Investors typically hold many stocks.
What happens when = 0?
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Type of Risk
• Systematic Risk
No diversifiable Risk = Market Risk war, inflation, recessions, and high
interest rates. Since most stocks are negatively affected
by these factors, market risk cannot be eliminated by diversification.
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Type of Risk
• Unsystematic Risk
diversifiable Risk Caused by such random events as
lawsuits, strikes, successful and unsuccessful marketing programs, winning or losing a major contract, and other events that are unique to a particular firm.
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Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification.
Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.
Stand-alone Market Diversifiable risk risk risk
= + .
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Capital AssetPricing Model (CAPM) an important tool used to analyze the
relationship between risk and rates of return .
The primary conclusion of the CAPM is this: The relevant risk of an individual stock is its contribution to the risk of a well-diversified portfolio
The risk that remains after diversifying is market risk, or the risk that is inherent in the market, and it can be measured by the degree to which a given stock tends to move up or down with the market.
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Capital AssetPricing Model (CAPM)
ri expected rate of return on the ith stock. ri required rate of return on the ith stock.
rRF risk-free rate of return. In this context,
rRF is generally measured by the return on long-term U.S. Treasury bonds.
bi beta coefficient of the ith stock. The beta of an average stock is bA = 1.0
^
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Capital AssetPricing Model (CAPM) rM required rate of return on a portfolio consisting of all
stocks, which is called the market portfolio. rM is also the required rate of return on an average (bA = 1.0)
stock. RPM = (rM - rRF)
risk premium on “the market,” and also on an average (b = 1.0) stock.
RPi = (rM - rRF) bi = (RPM)bi
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Security Market Line (SML)
Required return = Risk-free return + Premium for risk. the relationship between the required return
and risk is called the Security Market Line (SML).
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