Risk and Return: An Overview of Capital Market Theory

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Presentation transcript:

Risk and Return: An Overview of Capital Market Theory Chapter - 4 Risk and Return: An Overview of Capital Market Theory

Chapter Objectives Discuss the concepts of average and expected rates of return. Define and measure risk for individual assets. Show the steps in the calculation of standard deviation and variance of returns. Explain the concept of normal distribution and the importance of standard deviation. Compute historical average return of securities and market premium. Determine the relationship between risk and return. Highlight the difference between relevant and irrelevant risks. Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Return on a Single Asset Total return = Dividend + Capital gain Year-to-Year Total Returns on HLL Share Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Average Rate of Return The average rate of return is the sum of the various one-period rates of return divided by the number of period. Formula for the average rate of return is as follows: Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Risk of Rates of Return: Variance and Standard Deviation Formulae for calculating variance and standard deviation: Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Investment Worth of Different Portfolios, 1969–70 to 1997–98 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Averages and Standard Deviations, 1970–71 to 1997–98 Relative to 91-Days T-bills. # Relative to long-term government bonds. Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Expected Return : Incorporating Probabilities in Estimates The expected rate of return [E (R)] is the sum of the product of each outcome (return) and its associated probability: Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Expected Risk and Preference The following formula can be used to calculate the variance of returns: Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Expected Risk and Preference A risk-averse investor will choose among investments with the equal rates of return, the investment with lowest standard deviation. Similarly, if investments have equal risk (standard deviations), the investor would prefer the one with higher return. A risk-neutral investor does not consider risk, and would always prefer investments with higher returns. A risk-seeking investor likes investments with higher risk irrespective of the rates of return. In reality, most (if not all) investors are risk-averse. Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.

Normal Distribution Normal distribution is an important concept in statistics and finance. In explaining the risk-return relationship, we assume that returns are normally distributed. Normal distribution is a population-based, theoretical distribution. Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.