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Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Chapter 5
Risk and
Return
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-2
Learning Goals
1. Understand the meaning and fundamentals of risk,
return, and risk aversion.
2. Describe procedures for assessing and measuring the
risk of a single asset.
3. Discuss the measurement of return and standard
deviation for a portfolio and the concept of
correlation.
4. Understand the risk and return characteristics of a
portfolio in terms of correlation and diversification,
and the impact of international assets on a portfolio.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-3
Learning Goals (cont.)
5. Review the two types of risk and the derivation
and role of beta in measuring the relevant risk
of both a security and a portfolio.
6. Explain the capital asset pricing model
(CAPM) and its relationship to the security
market line (SML), and the major forces
causing shifts in the SML.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-4
Risk and Return Fundamentals
• If everyone knew ahead of time how much a stock would sell for
some time in the future, investing would be simple endeavor.
• Unfortunately, it is difficult—if not impossible—to make such
predictions with any degree of certainty.
• As a result, investors often use history as a basis for predicting
the future.
• We will begin this chapter by evaluating the risk and return
characteristics of individual assets, and end by looking at
portfolios of assets.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-5
Risk Defined
• In the context of business and finance, risk is defined
as the chance of suffering a financial loss.
• Assets (real or financial) which have a greater chance of loss are
considered more risky than those with a lower chance of loss.
• Risk may be used interchangeably with the term uncertainty to
refer to the variability of returns associated with a given asset.
• Other sources of risk are listed on the following slide.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-6
Table 5.1 Popular Sources of Risk Affecting
Financial Managers and Shareholders
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-7
Return Defined
• Return represents the total gain or loss on
an investment.
• The most basic way to calculate return is
as follows:
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-8
Robin’s Gameroom wishes to determine the returns on two of its
video machines, Conqueror and Demolition. Conqueror was
purchased 1 year ago for $20,000 and currently has a market value
of $21,500. During the year, it generated $800 worth of after-tax
receipts. Demolition was purchased 4 years ago; its value in the
year just completed declined from $12,000 to $11,800. During the
year, it generated $1,700 of after-tax receipts.
Return Defined (cont.)
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-9
Historical Returns
Table 5.2 Historical Returns for Selected
Security Investments (1926–2006)
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-10
Figure 5.1 Risk Preferences
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-11
Norman Company, a custom golf equipment manufacturer, wants
to choose the better of two investments, A and B. Each requires an
initial outlay of $10,000 and each has a most likely annual rate of
return of 15%. Management has estimated the returns associated
with each investment. The three estimates for each assets, along
with its range, is given in Table 5.3. Asset A appears to be less
risky than asset B. The risk averse decision maker would prefer
asset A over asset B, because A offers the same most likely return
with a lower range (risk).
Risk of a Single Asset
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-12
Risk of a Single Asset (cont.)
Table 5.3 Assets A and B
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-13
Risk of a Single Asset:
Discrete Probability Distributions
Figure 5.2 Bar Charts
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-14
Risk of a Single Asset:
Continuous Probability Distributions
Figure 5.3 Continuous Probability Distributions
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-15
Return Measurement for a Single Asset:
Expected Return
• The most common statistical indicator of an asset’s risk is the
standard deviation, k, which measures the dispersion
around the expected value.
• The expected value of a return, r-bar, is the most likely
return of an asset.

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fm2 chapter 1.pdf.pdf

  • 1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 5 Risk and Return
  • 2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-2 Learning Goals 1. Understand the meaning and fundamentals of risk, return, and risk aversion. 2. Describe procedures for assessing and measuring the risk of a single asset. 3. Discuss the measurement of return and standard deviation for a portfolio and the concept of correlation. 4. Understand the risk and return characteristics of a portfolio in terms of correlation and diversification, and the impact of international assets on a portfolio.
  • 3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-3 Learning Goals (cont.) 5. Review the two types of risk and the derivation and role of beta in measuring the relevant risk of both a security and a portfolio. 6. Explain the capital asset pricing model (CAPM) and its relationship to the security market line (SML), and the major forces causing shifts in the SML.
  • 4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-4 Risk and Return Fundamentals • If everyone knew ahead of time how much a stock would sell for some time in the future, investing would be simple endeavor. • Unfortunately, it is difficult—if not impossible—to make such predictions with any degree of certainty. • As a result, investors often use history as a basis for predicting the future. • We will begin this chapter by evaluating the risk and return characteristics of individual assets, and end by looking at portfolios of assets.
  • 5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-5 Risk Defined • In the context of business and finance, risk is defined as the chance of suffering a financial loss. • Assets (real or financial) which have a greater chance of loss are considered more risky than those with a lower chance of loss. • Risk may be used interchangeably with the term uncertainty to refer to the variability of returns associated with a given asset. • Other sources of risk are listed on the following slide.
  • 6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-6 Table 5.1 Popular Sources of Risk Affecting Financial Managers and Shareholders
  • 7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-7 Return Defined • Return represents the total gain or loss on an investment. • The most basic way to calculate return is as follows:
  • 8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-8 Robin’s Gameroom wishes to determine the returns on two of its video machines, Conqueror and Demolition. Conqueror was purchased 1 year ago for $20,000 and currently has a market value of $21,500. During the year, it generated $800 worth of after-tax receipts. Demolition was purchased 4 years ago; its value in the year just completed declined from $12,000 to $11,800. During the year, it generated $1,700 of after-tax receipts. Return Defined (cont.)
  • 9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-9 Historical Returns Table 5.2 Historical Returns for Selected Security Investments (1926–2006)
  • 10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-10 Figure 5.1 Risk Preferences
  • 11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-11 Norman Company, a custom golf equipment manufacturer, wants to choose the better of two investments, A and B. Each requires an initial outlay of $10,000 and each has a most likely annual rate of return of 15%. Management has estimated the returns associated with each investment. The three estimates for each assets, along with its range, is given in Table 5.3. Asset A appears to be less risky than asset B. The risk averse decision maker would prefer asset A over asset B, because A offers the same most likely return with a lower range (risk). Risk of a Single Asset
  • 12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-12 Risk of a Single Asset (cont.) Table 5.3 Assets A and B
  • 13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-13 Risk of a Single Asset: Discrete Probability Distributions Figure 5.2 Bar Charts
  • 14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-14 Risk of a Single Asset: Continuous Probability Distributions Figure 5.3 Continuous Probability Distributions
  • 15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-15 Return Measurement for a Single Asset: Expected Return • The most common statistical indicator of an asset’s risk is the standard deviation, k, which measures the dispersion around the expected value. • The expected value of a return, r-bar, is the most likely return of an asset.