...Risk and Return Concepts Prepared by: JQY Risk and Return Concepts • Measures of risk and returns • Portfolio risk and returns • CAPM Return – what is earned on an investment: the sum of income and capital gains generated by an investment. Risk – possibility of loss; the uncertainty that the anticipated return will not be achieved. Risk and Return? If you have PHP 1,000,000, will you invest in: 5% 20% Risk and Return General Rule of Thumb: More Risk = More Returns Less Risk = Less Returns It depends on the investor: Risk Seeking – prefers high risk investments Risk Neutral – willing to take on moderate risk Risk Averse – conservative, unwilling to take on high risk investments unless the returns justify and compensates for the high risk taken. Relative Risk & Returns of Asset Classes Source: http://www.weblivepro.com/articles/cpp/cppinfo.aspx Measures of Returns • Historical Returns ▫ Holding Period Return ▫ Alternative Measures Arithmetic Mean Geometric Mean Harmonic Mean • Expected Returns Measuring Historical Returns • Holding Period Return ▫ Total return on an asset or portfolio over the period during which it was held ▫ HPR = MV1 – MV0 + D MV0 MV1 = market value, end MV0 = market value, beginning D = cumulative cash distributions (at the end of period) • Annualized HPR ▫ (1 + HPR) ^ 1/n – 1 Measuring Historical Returns • Example: Mr. A bought an asset in 2005 for P100. He kept it...
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...CHAPTER 6 The Meaning and Measurement of Risk and Return CHAPTER ORIENTATION In this chapter, we examine the factors that determine rates of return (discount rates) in the capital markets. We are particularly interested in the relationship between risk and rates of return. We look at risk both in terms of the riskiness of an individual security and that of a portfolio of securities. CHAPTER OUTLINE I. Expected Return Defined and Measured A. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates. B. Conventionally, we measure the expected cash flow, [pic], as follows: [pic] = [pic]XiP(Xi) where n = the number of possible states of the economy Xi = the cash flow in the ith state of the economy P(Xi) = the probability of the ith cash flow II. Risk Defined and Measured A. Risk can be defined as the possible variation in cash flow about an expected cash flow. B. Statistically, risk may be measured by the standard deviation about the expected cash flow. III. Rates of Return: The Investors’ Experience A. Data have been compiled by Ibbotson and Associates on the actual returns for various portfolios of securities from 1926-1998. B. The following portfolios were studied: 1. Common stocks of large firms 2. Common stocks of small firms 3....
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...The return from holding an investment over some period of time is simply any cash payments received due to ownership, plus the change in market price usually expressed as a percent of the beginning market price of the investment. Return comes to you mainly from two sources – income or dividend plus any price appreciation (capital gain or loss) Dt + ( Pt – Pt-1) R = Pt-1 Suppose, you buy for Tk. 100 a security that would pay Tk. 7 in cash to you and be worth Tk. 106 one year later. This return would be (7 +6)/ 100 = 13%. Risk can be defined as the variability of return from those that are expected. In financial decisions it is often helpful to have an objective measure of risk. The main reason for having measuring of risk is to enable us to make better decisions. To be useful, a risk measure should enable us to rank alternative risky ventures. If there are two possibilities being analyzed, A and B, it is often important to know whether A is riskier than B or not. A good measure of risk should also tell us how much more risky A is than B. Is A twice as risky or ten times as risky as B? Is risky at all? Risk measurement procedures are usually based on a particular method of organizing financial problem -through probability distribution. (A set of possible values that a random variable can assume and their associated probabilities of occurrence.) Suppose you are thinking about purchasing stock A, which has a current...
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...Chapter 11 Return and Risk: The Capital Asset Pricing Model (CAPM) Copyright © 2015 by the McGraw-Hill Education (Asia). All rights reserved. 11.1 Individual Securities The characteristics of individual securities that are of interest are the: Expected Return Variance and Standard Deviation Covariance and Correlation (to another security or index) 11-1 11.2 Expected Return, Variance, and Covariance Consider the following two risky asset world. There is a 1/3 chance of each state of the economy, and the only assets are a stock fund and a bond fund. Scenario Recession Normal Boom Rate of Return Probability Stock Fund Bond Fund 33.3% -7% 17% 33.3% 12% 7% 33.3% 28% -3% 11-2 Expected Return Scenario Recession Normal Boom Expected return Variance Standard Deviation Stock Fund Rate of Squared Return Deviation -7% 0.0324 12% 0.0001 28% 0.0289 11.00% 0.0205 14.3% Bond Rate of Return 17% 7% -3% 7.00% 0.0067 8.2% Fund Squared Deviation 0.0100 0.0000 0.0100 11-3 Expected Return Scenario Recession Normal Boom Expected return Variance Standard Deviation Stock Fund Rate of Squared Return Deviation -7% 0.0324 12% 0.0001 28% 0.0289 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 0.0100 7% 0.0000 -3% 0.0100 7.00% 0.0067 8.2% E (rS ) 1 (7%) 1 (12%) 1 (28%) 3 3 3 E (rS ) 11% 11-4 Variance Scenario ...
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...Amortized Loan a loan that is paid off in equal periodic payments Risk potential variability in future cash flows standard deviation -a measure of risk when looking at stock in isolation standard deviation -measure of the dispersion of possible outcomes -Company-unique risk (unsystematic risk)-is diversifiable. This type of risk can be reduced through diversification. The result of factors that are unique to a particular firm -Market risk (systematic risk)is nondiversifiable. This type of risk cant be diversified away. -Market risk (systematic risk) -results from factors that affect all stocks. -Diversification investing in more than one security to reduce risk -Holding period returns the return an investor would receive for holding a security for a designated period of time. Beta the relationship between an investment's returns and the market's returns. Measurement of nondiversifiable risk. -Portfolio beta the relationship between a portfolio's returns and the market returns. It is a measure of the portfolio's nondiversifiable risk -Asset allocation identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of those assets within the portfolio -Required rate of return minimum rate of return necessary to attract an investor to purchase or hold a security (given risk) Risk Premium the additional return expected for assuming risk...
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...Merrill Finch Inc. Risk and Return Assume that you recently graduated with a major in finance. You just landed a job as a financial planner with Merrill Finch Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding pe riod. Further, your boss has restricted you to the investment alternatives in the following table, shown with their probabilities and associated outcomes. (For now, disregard the items at the bottom of the data; you will fill in the blanks later.) Returns on Alternative Investments Estimated Rate of Return State of the Economy Prob. T-Bills High Tech Collec- tions U.S. Rubber Market Portfolio 2-Stock Portfolio Recession 0.1 5.5% -27.0% 27.0% 6.0% a -17.0% 0.0% Below Avg. 0.2 5.5 -7.0 13.0 -14.0 -3.0 Average 0.4 5.5 15.0 0.0 3.0 10.0 7.5 Above Avg. 0.2 5.5 30.0 -11.0 41.0 25.0 Boom 0.1 5.5 45.0 -21.0 26.0 38.0 12.0 r-hat ( r ˆ ) 1.0% 9.8% 10.5% Std. dev. ( ) 0.0 13.2 18.8 15.2 3.4 Coeff. of Var. (CV) 13.2 1.9 1.4 0.5 beta (b) -0.87 0.88 a Note that the estimated returns of U.S. Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy were stronger. However, if the economy is in a flat-out recession, a large number...
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...Chapter 5 Risk and Return 5.1 RATES OF RETURN McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Learning objectives Use data on the past performance of stocks and bonds to characterize the risk and return features of these investments Determine the expected return and risk of portfolios that are constructed by combining risky assets with risk-free investment in Treasury bills Evaluate the performance of a passive strategy McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Holding Period Return The holding period return (HPR)(보유기간수익률) Depends on the increase (or decrease) in the price of the share over the investment period as well as on any dividend income. Rate of return over a given investment period McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Example 5.1 Suppose you are considering investing some of your money, now all invested in a bank account, in a stock market index fund. The price of a share in the fund is currently $100, and your time horizon is one year. You expect the cash dividend during the year to be $4, so your expected dividend yield is 4%. Your HPR will depend on the price one year from now. Suppose your best guess is that it will be $110 per share. The your capital gain will be $10 (110-100), so your capital gains yield is $10/$100=.10 or 10%. The total holding period rate of return is the sum of the dividend...
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...report on Risk-return tradeoff Submitted by Pradip Routh Reg. no - 0906247013 Introduction :People have many motives for investing. For most investors, however, their interest in investment is largely pecuniary- to earn a return on their money. However, selecting stocks exclusively on the basis of maximization of return is not enough. To sat that investors like return and dislike risks is, however, simplistic. To facilitate our job for analyzing securities and portfolio within a return-risk context are, we must begin with a clear understanding of what risk and return are, what creates them, and how they should be measured. The ultimate decisions to be made in investment are (1 ) what securities should be held and (2) how much money should be allocated to each. These decisions are normally made in two steps. First estimates are prepared of the return and risk associated with available securities over a forward holding period. This step is known as security analysis. Second risk-return estimates must be compared in order to decide how to allocate available funds among these securities on a continuing basis. Security analysis is built around the idea that investors are concerned with two principle properties inherent in securities; the return that can be expected from holding a security, and the risk that the return that is achieved will be less than the return that was expected. The primary purpose herein is to focus upon return and risk and how they...
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...in the following years, calculate the geometric average annual return from the following sequence of returns: YR 1 = +.20, YR 2 = .15, YR 3 = +.10, YR 4 = +.06 (a) .1263 (b) .0525 (c) .0835 (d) .0443 According to modern portfolio theory, the idea that investors with different indifference curves will hold the same portfolio of risky securities is a result of: (a) diminishing marginal utility of income (b) covariance (c) the separation theorem (d) the normal distribution assumption Within the framework of modern portfolio theory, if portfolios A and B have the same return but portfolio A has less risk, then: (a) portfolio B is inefficient (b) portfolio A is inefficient (c) portfolio B cannot exist (d) you must hold both A and B In a portfolio where you own positive amounts of two risky assets, the standard deviation of the portfolio cannot be reduced below the standard deviation of the lower risk asset if the correlation of returns between the two assets is: (a) 0 (b) 1.0 (c) -1.0 (d) none of the above According to modern portfolio theory, a risk neutral investor will choose an optimal portfolio (a) to maximize risk (b) to maximize return (c) to minimize risk (d) any of the above The capital allocation line will be a straight line: (a) when investors can borrow and lend at the risk free rate (b) when investors are risk neutral (c) when securities have zero covariance (d) when the risk free asset has the highest return of any security (e) all of the above Within the framework of the...
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...various securities — consisting of Government and semi Govt. securities, loans, debentures, shares and bonds etc. ❖ Elements of Investment :- a) Reward (Return) b) Risk and Return c) Time ❖ Nature of Investment :- Investment requires a continuous flow of decisions which can not be avoided. The investment decisions are based on many streams of data which taken together, represent to an investor the observable environment and the general and particular of the securities & enterprises in which he may invest. ❖ Investment Environment :- a) Stable Government b) Stable Currency c) Presence of Public financial Institutions d) Development of corporate sector. [pic] ❖ Different types of Port-folios for Investment :- Investment — Concept of Port-folio :- Portfolio is the collection of financial or real assets such as equity shares or debentures, bonds, treasury bills & property etc. Steps in selecting a portfolio a) framing of investment policies. b) Valuation of Financial Instruments c) Investment Analysis d) Construction of Portfolio Port-folio management is the investment of funds in different securities in which total risk of the port-folio is minimized while expecting maximum return form it. ❖ Port-folio construction :- i) Determination of Diversification level. ii) Consideration of Investment timings. iii) Selection of Investment...
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...Chapter 7—Risk, Return, and the Capital Asset Pricing Model MULTIPLE CHOICE 1. Suppose Sarah can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios should she hold in combination with a position in the risk-free asset? a. portfolio with a standard deviation of 15% and an expected return of 12% b. portfolio with a standard deviation of 19% and an expected return of 15% c. portfolio with a standard deviation of 25% and an expected return of 18% d. portfolio with a standard deviation of 12% and an expected return of 9% ANS: B To determine which portfolio is the best, draw a line from the risk-free rate to each dot in the figure and choose the line with the highest slope. DIF: H REF: 7.3 The Security Market Line and the CAPM 2. Suppose David can borrow and lend at the risk-free rate of 5%. Which of the following three risky portfolios should he hold in combination with a position in the risk-free asset? a. portfolio with a standard deviation of 16% and an expected return of 12% b. portfolio with a standard deviation of 20% and an expected return of 16% c. portfolio with a standard deviation of 30% and an expected return of 20% d. he should be indifferent in holding any of the three portfolios ANS: B To determine which portfolio is the best, draw a line from the risk-free rate to each dot in the figure and choose the line with the highest slope. DIF: H REF: 7.3 The Security Market Line and the CAPM 3. The risk-free...
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...SETTING TRUE/FALSE 1. The rate of exchange between certain future dollars and certain current dollars is known as the pure rate of interest. ANS: T PTS: 1 2. An investment is the current commitment of dollars over time to derive future payments to compensate the investor for the time funds are committed, the expected rate of inflation and the uncertainty of future payments. ANS: T PTS: 1 3. The holding period return (HPR) is equal to the holding period yield (HPY) stated as a percentage. ANS: F PTS: 1 4. The geometric mean of a series of returns is always larger than the arithmetic mean and the difference increases with the volatility of the series. ANS: F PTS: 1 5. The expected return is the average of all possible returns. ANS: F PTS: 1 6. Two measures of the risk premium are the standard deviation and the variance. ANS: F PTS: 1 7. The variance of expected returns is equal to the square root of the expected returns. ANS: F PTS: 1 8. The coefficient of variation is the expected return divided by the standard deviation of the expected return. ANS: F PTS: 1 9. Nominal rates are averages of all possible real rates. ANS: F PTS: 1 10. The risk premium is a function of the volatility of operating earnings, sales volatility and inflation. ANS: F PTS: 1 11. An individual who selects the investment that offers greater certainty when everything else is the same is known as a risk averse investor. ANS: T PTS:...
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...CHAPTER 2 RISK AND RETURN: PART I (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Easy: (2.2) Payoff matrix Answer: a Diff: E [i]. If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns. a. True b. False (2.2) Standard deviation Answer: a Diff: E [ii]. The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation. a. True b. False (2.2) Coefficient of variation Answer: a Diff: E [iii]. The coefficient of variation, calculated as the standard deviation divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False (2.2) Risk comparisons Answer: a Diff: E [iv]. The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the securities being compared differ significantly. a. True b. False (2.3) Risk and expected return Answer: a Diff: E [v]. Companies should deliberately increase their risk relative to the market only if the actions that increase the risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the higher risk. a. True b. False (2.2) Risk aversion...
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...__________ risk of the portfolio decreases until 10 to 20 securities are included. The portion of the risk eliminated is __________ risk, while that remaining is __________ risk * o diversifiable; nondiversifiable; total o relevant; irrelevant; total o total; diversifiable; nondiversifiable o total; nondiversifiable; diversifiable The higher an asset's beta, * o the more responsive it is to changing market returns o the higher the expected return will be in a down market o the lower the expected return will be in an up market o the less responsive it is to changing market returns __________ probability distribution shows all possible outcomes and associated probabilities for a given event * o A continuous o An expected value o A discrete o A bar chart A beta coefficient of 0 represents an asset that * o is less responsive than the market portfolio o has the same response as the market portfolio o is more responsive than the market portfolio o is unaffected by market movement The financial manager's goal for the firm is to create a portfolio that maximizes return in order to maximize the value of the firm * o False o True The security market line (SML) reflects the required return in the marketplace for each level of nondiversifiable risk (beta) * 212 Gitman • Principles of Finance, Eleventh Edition o False o True The portion of an asset's risk that is attributable to firm-specific, random causes is called * o systematic risk o unsystematic...
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...Risk and Rates of Return Risk – The chance that some unfavorable event will occur; investment risk can be measured by the variability of the investment’s return. Stand-Alone Risk • Probability Distributions Subjective (estimated) Objective (historical) Continuous Discrete • Expected Rate of Return … weighted average of all possible outcomes … the rate of return expected to be realized from an investment … the mean value of the probability distribution of possible results • Variance ((2) • Standard Deviation (() … measures total risk • Coefficient of Variation (CV = (/k) … measures risk per unit of return … can be used to rank stocks based upon their risk/return characteristics … the CV is most useful when analyzing investments that have different expected rates of return and different levels of risk • Risk Aversion … the greater a security’s risk, the greater the return investors will demand and thus the less they are willing to pay for the investment • Risk Premium …the portion of a security’s expected return that is attributed to the additional risk of an investment over and above the “risk-free” rate of return Portfolio Risk • Portfolio – a collection or grouping of investment securities or assets • Efficient Portfolio 1) Maximize return for a given level of risk 2) Minimize risk for a given level...
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