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# Risk And Returns

## on Oct 11, 2009

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## Risk And ReturnsPresentation Transcript

• Risk and Rates of Return Return Risk
• Since Treasury’s are essentially free of default risk, the rate of return on a Treasury security is considered the “risk-free” rate of return.
For a Treasury security, what is the required rate of return? Required rate of return = Risk-free rate of return
• How large of a risk premium should we require to buy a corporate security?
Required rate of return = Risk-free rate of return + Risk Premium For a corporate stock or bond , what is the required rate of return?
• Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.
• Required Return - the return that an investor requires on an asset given its risk .
Returns
• State of Probability Return
• Economy (P) Orl. Utility Orl. Tech
• Recession .20 4% -10%
• Normal .50 10% 14%
• Boom .30 14% 30%
• For each firm, the expected return on the stock is just a weighted average :
Expected Return
• State of Probability Return
• Economy (P) Orl. Utility Orl. Tech
• Recession .20 4% -10%
• Normal .50 10% 14%
• Boom .30 14% 30%
• For each firm, the expected return on the stock is just a weighted average :
• k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(k n )*kn
Expected Return
• State of Probability Return
• Economy (P) Orl. Utility Orl. Tech
• Recession .20 4% -10%
• Normal .50 10% 14%
• Boom .30 14% 30%
• k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(k n )*kn
• k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
Expected Return
• State of Probability Return
• Economy (P) Orl. Utility Orl. Tech
• Recession .20 4% -10%
• Normal .50 10% 14%
• Boom .30 14% 30%
• k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(k n )*kn
• k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
Expected Return
• The possibility that an actual return will differ from our expected return.
• Uncertainty in the distribution of possible outcomes.
What is Risk?
• What is Risk?
• Uncertainty in the distribution of possible outcomes.
Company B return Company A return
• A more scientific approach is to examine the stock’s STANDARD DEVIATION of returns.
• Standard deviation is a measure of the dispersion of possible outcomes.
• The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK.
How do we Measure Risk?
• = (k i - k) P(k i )
n i =1 2   Standard Deviation
• Orlando Utility, Inc.
• ( 4% - 10%) 2 (.2) = 7.2
• (10% - 10%) 2 (.5) = 0
• (14% - 10%) 2 (.3) = 4.8
• Variance = 12
• Stand. dev. = 12 = 3.46%
n i =1 = (k i - k) P(k i ) 2  
• Orlando Technology, Inc.
• (-10% - 14%) 2 (.2) = 115.2
• (14% - 14%) 2 (.5) = 0
• (30% - 14%) 2 (.3) = 76.8
• Variance = 192
• Stand. dev. = 192 = 13.86%
= (k i - k) P(k i ) 2   n i =1
• Orlando Orlando
• Utility Technology
• Expected Return 10% 14%
• Standard Deviation 3.46% 13.86%
Summary