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Analysis of Risk
and Return
Finance 311
Introduction
Finance 311
RETURN - TERMINOLOGY
Ex-Ante Returns
Ex-Post Returns
HPRs - covered previously
Finance 311
Expected Return
Given Probability
Distribution
n
r rjpj
j 1
Finance 311
Risk
Finance 311
Expected Return
Risk Premium
Finance 311
Business risk
Financial risk
Risk-Return Relationship
Required return = Risk-free return + Risk
premium
Real rate of return
Risk-free rate
Expected inflation
premium
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http://publicdebt.treas.gov/sav/sbirate2.
htm
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Expected Inflation
Premium
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13
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MEASURING RISK
US Treasury Securities
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Standard Deviation
Ex-Ante Data(probability
distribution)
r r
n
pj
j 1
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Standard Deviation
r r
n
j 1
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n 1
18
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Coefficient of Variation
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Standard deviation
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Diversification
22
Diversification
Systematic (undiversifiable)
Risk
Unsystematic (diversifiable)
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Mathematics of
Portfolios
rp wara wbrb
24
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Mathematics of Portfolios
-- continued.
wA A wB B 2wA wB A B
2
Correlation Coefficient
27
Characteristics of Securities
Comprising a Portfolio
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Efficient Portfolio
r
Has the highest
possible return for
a given
Has the lowest
possible for a
given expected
return
Risk
a and c are preferred to b
a and c are efficient
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32
CAPM
Only Systematic Risk is Relevant
Systematic risk
caused by factors
affecting the market
as a whole:
interest rate changes
changes in
purchasing power
change in business
outlook
terrorist attacks
Unsystematic risk
caused by factors
unique to a firm or
industry:
foreign competition
government
regulations
managements
capabilities
strikes
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Since by diversifying an
investor can eliminate
unsystematic risk, we need to
be able to measure the
amount of systematic risk in a
portfolio
Systematic Risk is Measured
by Beta ()
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34
Systematic Risk is
Measured by Beta
A measure of the volatility of a securitys
return compared to the Market Portfolio
Covariance j , m
Variance m
35
kj = a r
j m+
j
Beta here is
historical.
ej
Finance 311
Return
on
Market
Index
36
More on Betas
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Important Points to
Remember About Risk
Measurement
38
Important Points to
Remember About Risk
Measurement -continued
39
SML
rf
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Beta
= Systematic risk
k j = ^rf + j (^rm^- rf )
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Beta
j = Covariance j, m
Variance m
j = jm j m
m2
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k j r^ j (r^ r^ )
f
m f
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Risk Premium
44
CAPM Assumptions
Investors are
influenced by
systematic risk
Freely available
information
No brokerage charges
Investors have
homogeneous
expectations
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International
Investing
49
High-Yield or High-Risk
Securities
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Ethical Issues
Executive Life
Company Practices
ENRON
Health South
World Com MCI
Adelphia Communications
TYCO
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Conclusion
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