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Finance Chapter 5 Risk & rates of return. No pain no gain  What is risk?  How is risk measured?  How can risk be minimized or at least compensated.

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Presentation on theme: "Finance Chapter 5 Risk & rates of return. No pain no gain  What is risk?  How is risk measured?  How can risk be minimized or at least compensated."— Presentation transcript:

1 Finance Chapter 5 Risk & rates of return

2 No pain no gain  What is risk?  How is risk measured?  How can risk be minimized or at least compensated for bearing it?  Investors like returns and dislike risk  Investors will invest in risky assets only if they expect to receive higher returns

3 Risk in perspective  The riskiness of an asset can be considered in two ways:  Stand-alone—an assets cash flows are analyzed by themselves  Portfolio context—cash flows from a number of assets are combined (consolidated) and analyzed

4 Risk analysis considerations  Portfolio context  Diversifiable risk—risk that is eliminated through diversification (irrelevant)  Market risk—cannot be eliminated thru diversification (relevant)  An asset with a high degree of market risk (relevant) must provide a high rate of return to attract investors  Remember that investors are averse to risk

5 Investment returns  Measuring rates of return problem:  Scale (size of investment)  Timing problem  Solution:  Rates of return or percentage of return for a one year investment  ROR = (amount rec’d - amount invested) / amount invested

6 Stand-alone risk  Risk—the chance that some unfavorable event will occur  Stand-alone risk—the risk an investor would face if s/he held only one asset  Probability—the chance an event will occur  Probability distribution—a listing of all possible outcomes (events) with a chance of occurrence (probability) assigned to each outcome  Probabilities must add up to 100%  See Table 5-1, pg. 172

7 Expected rate of return  Expected rate of return, k (k-hat)—the rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results (payoff matrix)

8 Stand-alone risk  The tighter the probability distribution of expected future returns, the smaller the risk of a given investment (see figure 5-2, page 174)  Standard deviation (sigma)—the smaller the standard deviation, the tighter the probability distribution, and the lower the riskiness of a stock.  Standard deviation is essentially a weighted average of the deviations from the expected value.

9 Stand-alone risk  Coefficient of variation (CV)—the standard deviation divided by the expected return.  CV = Standardized measure of the risk per unit of return used for investments that have the same expected returns but different standard deviations.

10 Risk Aversion  Most investors are risk averse.  The higher a security’s risk the lower its price and the higher its required return.  Risk Premium (RP)—the difference between the expected rate of return on a given risky asset and that on a less risky investment = increased compensation required for a risky investment

11 Portfolio returns & risk  Expected return on a portfolio k p (k-hat p)= the weighted average of the expected returns on assets held in the portfolio  Realized rate of return k (k-bar) = the return that was actually earned during some past period. K- bar usually is different from the expected (k-hat) except for riskless assets.

12 Correlation coefficients  Correlation = the tendency of 2 variables to move together  Correlation coefficient, r = measures the degree of relationship between 2 variables (the tendency to correlate movements)  r can range from +1.0 (perfectly positive correlation - move up and down together) to (perfectly negative correlation - move in opposite directions) while 0 means they are independent of one another.  Diversification means nothing if all stocks are perfectly correlated

13 Diversifiable risk vs. market risk  Almost half the riskiness of an average stock can be eliminated if the stock is held in a diversified portfolio containing at least 40 stocks  Market risk—that part of security’s risk that cannot be eliminated by diversification.  Capital Asset Pricing Model (CAPM)—a stock’s required ROR is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.  Relevant risk—the risk remaining after diversification that cannot be diversified away (aka, market risk)

14 The concept of Beta (b)  Beta coefficient, b—a measure of market risk, which is the extend to which the returns on a given stock move with the stock market.  b measures the volatility of a stock, e.g., 1.0 (high beta)stocks will move up and down with the broad market averages. 0.5 (low beta) stocks are half as volatile as the market averages. A negative b means the stock will move in the opposite direction as the market average.

15 Market risk premium  RP m –the additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.  Security Market Line (SML)—the relationship between a security’s market risk and its required rate of return. The return required for any security is equal to the risk-free rate plus the market risk premium times the security’s beta: k i = k rf + (k m – k rf )b i

16 Factors effecting RROR  Risk-free rate change (real rates or inflation)  Change in a stock’s beta  Investors’ aversion to risk can change  Global diversification may result in lower risk for multinational companies and globally diversified portfolios.

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