...CHAPTER 5 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML 5-1 Investment returns The rate of return on an investment can be calculated as follows: Return = (Amount received – Amount invested) ________________________ Amount invested 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%. 5-2 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. 5-3 Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Firm X Firm Y -70 0 15 Expected Rate of Return 100 Rate of Return (%) 5-4 Selected Realized Returns, 1926 – 2001 Small-company stocks Large-company stocks L-T corporate bonds L-T government bonds U.S. Treasury bills Average Return 17.3% 12.7 6.1 5.7 3.9 Standard Deviation 33.2% 20.2 8.6 9.4 3.2 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28. 5-5 Investment alternatives Economy Prob. T-Bill HT Coll USR MP Recession ...
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