Chapter 13 Risk and Return 0
0 Chapter 13 Risk and Return
Chapter Outline Expected Returns and Variances ■Portfolios Announcements,Surprises,and Expected Returns Risk:Systematic and Unsystematic Diversification and Portfolio Risk a Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital:A Preview
1 Chapter Outline n Expected Returns and Variances n Portfolios n Announcements, Surprises, and Expected Returns n Risk: Systematic and Unsystematic n Diversification and Portfolio Risk n Systematic Risk and Beta n The Security Market Line n The SML and the Cost of Capital: A Preview
Key Concepts and Skills Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand the security market line Understand the risk-return trade-off 2
2 Key Concepts and Skills n Know how to calculate expected returns n Understand the impact of diversification n Understand the systematic risk principle n Understand the security market line n Understand the risk-return trade-off
Expected Returns Expected returns are based on the probabilities of possible outcomes In this context,“expected”means“average if the process is repeated many times The "expected"return does not even have to be a possible return E(R)=∑p,R i=l
3 Expected Returns n Expected returns are based on the probabilities of possible outcomes n In this context, “expected” means “average” if the process is repeated many times n The “expected” return does not even have to be a possible return n i E R piRi 1 ( )
Example:Expected Returns Suppose you have r predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession ?? 0.02 0.01 Rc=.3(.15)+.5(.10)+.2(.02)=.099=9.9% RT=.3(.25)+.5(.20)+.2(.01)=.177=17.7% 4
4 Example: Expected Returns n Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.9% RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7% State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession ??? 0.02 0.01
Variance and Standard Deviation Variance and standard deviation still measure the volatility of returns Using unequal probabilities for the entire range of possibilities Weighted average of squared deviations o2-∑p,(R-E(R2 i=l 5
5 Variance and Standard Deviation n Variance and standard deviation still measure the volatility of returns n Using unequal probabilities for the entire range of possibilities n Weighted average of squared deviations n i pi Ri E R 1 2 2 σ ( ( ))
Example:Variance and Standard Deviation Consider the previous example.What are the variance and standard deviation for each stock? State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession ?? 0.02 0.01 Stock C 62=.3(.15-.099)2+.5(.1-.099)2+.2(.02-.099)2=.002029 0=.045 Stock T 2=.3(.25-.177)2+.5(.2-.177)2+.2(.01-.177)2=.007441 6=.0863 6
6 Example: Variance and Standard Deviation n Consider the previous example. What are the variance and standard deviation for each stock? n Stock C 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029 = .045 n Stock T 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441 = .0863 State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession ??? 0.02 0.01
Another Example Consider the following information: State Probability Ret.on ABC,Inc ▣ Boom .25 .15 o Normal .50 .08 Slowdown .15 .04 Recession .10 -.03 What is the expected return? ■Vhat is the variance? What is the standard deviation?
7 Another Example n Consider the following information: q State Probability Ret. on ABC, Inc q Boom .25 .15 q Normal .50 .08 q Slowdown .15 .04 q Recession .10 -.03 n What is the expected return? n What is the variance? n What is the standard deviation?
Portfolios A portfolio is a collection of assets An asset's risk and return are important to how the stock affects the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation,just as with individual assets 8
8 Portfolios n A portfolio is a collection of assets n An asset’s risk and return are important to how the stock affects the risk and return of the portfolio n The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets
Example:Portfolio Weights ■ Suppose you have $15,000 to invest and you have purchased securities in the following amounts.What are your portfolio weights in each security? 口$2,000 of DCLK DCLK:2/15=.133 ▣$3,000ofKO K0:3/15=.2 0 $4,000 of INTC lNTC:4/15=.267 $6,000 of KEl KE:6/15=.4 9
9 Example: Portfolio Weights n Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? q $2,000 of DCLK q $3,000 of KO q $4,000 of INTC q $6,000 of KEI •DCLK: 2/15 = .133 •KO: 3/15 = .2 •INTC: 4/15 = .267 •KEI: 6/15 = .4