Chapter 8 Risk and Required Return

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Presentation transcript:

Chapter 8 Risk and Required Return Presentation Chapter 8 Risk and Required Return

Capital Asset Pricing Model (CAPM) A theoretical framework for explaining the relationship between risk and return. Risk, Two definitions: Actual return will be less than the expected return. Variability of return from the investment.

Standard Deviation (σ) A measure of the dispersion of returns in a normal probability distribution. Particularly useful because: 6σ = Virtually the entire range. 4σ = two-thirds of the range.

Capital Asset Theory A powerful model of the relationships between risk with return. A high-risk proposal must offer a higher forecasted return than a lower-risk proposal.

What is “Return?” CAPM uses two independent analyses of return. Likely Return. The probable or expected return from the investment. Required Return. How much return is needed given the risk level.

The Market Line – Must Have

The Market Line with Inefficiencies.

Indifference Curve – Required Return The trade-off between risk and return.

Optimal Investment

Optimal Investment -- Want theory? Using (σ) as the risk measure, required return is calculated: E(Rtn)req = E(Rtn)riskfree + [Exc(Rtn)mkt]*[ σasset/σmkt] where Exc(Rtn)mkt is the excess return on the market portfolio is calculated by subtracting the risk-free return from the market return.