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Lecture Fundamentals of financial management - Chapter 5: Risk and rates of return
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Chapter 5: Risk and rates of return. This chapter presents the following content: Investment returns, what is investment risk?, probability distributions, investment alternatives, Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return? How do the returns of HT and Coll. behave in relation to the market?. | CHAPTER 5 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML Investment returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return = Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%. What is investment risk? Two types of investment risk Stand-alone risk Portfolio risk Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y Selected Realized Returns, 1926 – 2001 Average Standard Return Deviation Small-company stocks 17.3% 33.2% Large-company stocks 12.7 20.2 L-T corporate bonds 6.1 8.6 L-T government bonds 5.7 9.4 U.S. Treasury bills 3.9 3.2 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28. Investment alternatives Economy Prob. T-Bill HT Coll USR MP Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0% Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0% Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0% Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0% Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0% Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return? T-bills will return the promised 8%, regardless of the economy. No, T-bills do not provide a risk-free return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time. T-bills are also risky in terms of reinvestment rate risk. T-bills are risk-free in the default sense of the word. How do the returns of HT . | CHAPTER 5 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML Investment returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return = Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%. What is investment risk? Two types of investment risk Stand-alone risk Portfolio risk Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 15 0 -70 Firm X Firm Y Selected Realized Returns, 1926 – 2001 Average Standard Return Deviation Small-company stocks 17.3% 33.2% .