CHAPTER 9 – CHARACTERIZING RISK AND RETURN

Questions

LG1 1. Why is the percentage return a more useful measure than the dollar return?

The dollar return is most important relative to the amount invested. Thus, a $100 return is more impressive from a $1,000 investment than a $5,000 investment. The percentage return incorporates both the dollar return and the amount invested. Therefore, it is easier to compare percentage return across different investments.

LG2 2. Characterize the historical return, risk, and risk-return relationship of the stock, bond and cash markets.

Examining Table 9.2, it is clear that the stock market has earned about double the return since 1950 than bonds. Bonds have earned about 50% higher return than the cash markets. The risk in the stock market is also higher than the bond and cash markets according to the standard deviation measurement (Table 9.4). Another illustration of the high risk is that the stock market frequently losses money and sometimes does not earn more than the bond and cash markets over short periods of time (Table 9.2). The risk-return relationship tells us that we should expect higher returns for the riskier market. We do see higher realized returns over the long term to the higher risk asset classes.

LG3 3. How do we define risk in this chapter and how do we measure it?

Risk is defined as the volatility of an asset’s returns over time. Specifically, the standard deviation of returns is used to measure risk. This computation measures the deviation from the average return. The idea is to use standard deviation, a measure of volatility of past returns to proxy for how variable returns are expected to be in the future.

LG3 4. What are the two components of total risk? Which component is part of the risk-return relationship? Why?

Total risk includes firm specific risk and market risk.