Chapter 5 Risk and return 5-1
5-1 Chapter 5 Risk and Return
Risk and return n Defining Risk and return n Using Probability Distributions to Measure risk n Attitudes toward risk o Risk and return in a portfolio context o Diversification n The Capital Asset Pricing Model (CAPM) 5-2
5-2 Risk and Return Defining Risk and Return Using Probability Distributions to Measure Risk Attitudes Toward Risk Risk and Return in a Portfolio Context Diversification The Capital Asset Pricing Model (CAPM)
Defining Return Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment D t(t P t-1 R Pt-1 5-3
5-3 Defining Return Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment. Dt + (Pt - Pt-1 ) Pt-1 R =
Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year? 1.00+($9.50-510.00) R $1000 5% 5-4
5-4 Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year? $1.00 + ($9.50 - $10.00 ) $10.00 R = = 5%
Defining Risk The variability of returns from those that are expected. What rate of return do you expect on your investment(savings) this year? What rate will you actually earn? Does it matter if it is a bank cd or a share of stock? 5-5
5-5 Defining Risk What rate of return do you expect on your investment (savings) this year? What rate will you actually earn? Does it matter if it is a bank CD or a share of stock? The variability of returns from those that are expected
Determining Expected Return REX(RPi R is the expected return for the asset, Ri is the return for the ith possibility Pi is the probability of that return occurring, n is the total number of possibilities 5-6
5-6 Determining Expected Return R = ( Ri )( Pi ) R is the expected return for the asset, Ri is the return for the ith possibility, Pi is the probability of that return occurring, n is the total number of possibilities. n i=1
Determining standard Deviation(Risk Measure) =V∑(R1-R)2(P1) Standard Deviation, o is a statistical measure of the variability of a distribution around its mean It is the square root of variance. 5-7
5-7 Determining Standard Deviation (Risk Measure) = ( Ri - R ) 2 ( Pi ) Standard Deviation, , is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. n i=1
How to Determine the Expected Return and standard Deviation Stock BW R P.(R)P)(R-R)2P) 15 10 -015 00576 03 20 006 00288 09 40 036 00000 21 20 042 00288 33 10 033 00576 Sum 1.00 090 07728 5-8
5-8 How to Determine the Expected Return and Standard Deviation Stock BW Ri Pi (Ri )(Pi ) (Ri - R ) 2 (Pi ) -.15 .10 -.015 .00576 -.03 .20 -.006 .00288 .09 .40 .036 .00000 .21 .20 .042 .00288 .33 .10 .033 .00576 Sum 1.00 .090 .01728
Determining standard Deviation(Risk Measure) (R;-R)2(P) d=V.01728 a=:1315or13.15% 5-9
5-9 Determining Standard Deviation (Risk Measure) = ( Ri - R ) 2 ( Pi ) = .01728 = .1315 or 13.15% n i=1
Coefficient of variation The ratio of the standard deviation of a distribution to the mean of that distribution It is a measure of relatve risk CV=0/R CV of bw=1315/09=146 5-10
5-10 Coefficient of Variation The ratio of the standard deviation of a distribution to the mean of that distribution. It is a measure of RELATIVE risk. CV = / R CV of BW = .1315 / .09 = 1.46