Risk And Returns
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Risk And Returns

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Risk And Returns Risk And Returns Presentation 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