1."Why is expected return considered forward-looking? What are the challenges for practitioners to utilize expected return?" (Cornett, Adair, and Nofsinger, 2012, p. 246). Expected return is “forward-looking” in the sense that it represents the return investors expect to receive in the future as compensation for the market risk taken. The challenge is that practitioners cannot precisely know what the future holds and thus what the expected return should be. Thus, we create methods to estimate the expected return. 2. "Describe how different allocations between the risk-free security and the market portfolio can achieve any level of market risk desired." (Cornett, Adair, and Nofsinger, 2012, p. 246). An investor can allocate money between a risk-free security that has zero risk (β=0), and the market portfolio that has market risk (β=1). If 75% of the portfolio is invested in the market, then the portfolio will have a β=0.75. If only 25% is invested in the market, then the portfolio will have a market risk of β=0.25. The first example (β=0.75) might be taken by a less risk averse investor while the second example (β=0.25) illustrates the portfolio of a more risk averse investor. By allocating the investment money between 0 and 100% into the market portfolio, an investor can achieve any level of market risk desired. 3. "Compute the expected return given these three economic states, their likelihoods, and the potential returns:"

Economic StateProbabilityReturn
Fast Growth0.3040%
Slow Growth0.5010%
Recession0.20−25%

Expected return = 0.3×40% + 0.5×10% + 0.2×-25% = 12%
4. "If the risk-free rate is 6 percent and the risk premium is 5 percent, what is the required return?" (Cornett, Adair, and Nofsinger, 2012, p. 247). Required return = 6% + 5% = 11%
5. "The average annual return on the Standard and Poor's 500 Index from 1986 to 1995 was 15.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk...

...RISK & RETURN
TOPIC 4
Learning Objectives
1. Understand the meaning of risk and return
2. Identify risk and return relationship
3. Discuss the measurement of expected return
and standard deviation
4. Understand portfolio and diversification
5. Distinguish the different types of investment
risks
6. Measurement of return based on CAPM
WRMAS
2RETURN DEFINED
• Return represents the total gain or loss on an investment.
•
Basic concept:
Each investor desires a return for every single dollar of their
investment.
Example 1:
Rita invests in 10 unit shares valued at RM1000. At the end of
year, she sells all the shares @ RM1100. How much return
received by Rita for her investment?
RM100 (Holding return dollar gain)
r = RM1,100 + 0 – RM1,000
RM1,000
= 10% (so holding period rate of return is 10%)
WRMAS
3
Return Defined
Exercise 1
Calculate the holding period rate of return of each
quarter below.
1st Quarter
2nd Quarter
3rd Quarter
4th Quarter
Dividend
0.50
1.20
0
1.95
Purchase price
100
98
101
102
Selling Price
98
101
102
108
HP Rate of
Return
?
?
?
?
WRMAS
4
EXPECTED RETURN
• Expected...

...expected return on a risky asset.
c. the expected return on a collection of risky assets.
d. the variance of returns for a risky asset.
e. the standard deviation of returns for a collection of risky assets.
PORTFOLIO WEIGHTS
2. The percentage of a portfolio’s total value invested in a particular asset is called that asset’s:
a. portfolio return.
b. portfolio weight.
c. portfoliorisk.
d. rate of return.
e. investment value.
SYSTEMATIC RISK
3. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.
a. idiosyncratic
b. diversifiable
c. systematic
d. asset-specific
e. total
UNSYSTEMATIC RISK
4. Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. undiversifiable
c. market
d. unsystematic
e. total
PRINCIPLE OF DIVERSIFICATION
5. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of your risk.
b. concentrating an investment in three companies all within the same industry will greatly reduce your overall risk.
c. spreading an investment across five diverse companies will not lower your...

...themselves to risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to take on. If you invest in stocks and have trouble sleeping at night, you are probably taking on too much risk. Risk is defined as the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment.
A financial decision typically involves risk. For example, a company that borrows money faces the risk that interest rates may change, and a company that builds a new factory faces the risk that product sales may be lower than expected. These and many other decisions involve future cash flows that are risky. Investors generally dislike risk, but they are also unable to avoid it.
To make effective financial decisions, managers need to understand what causes risk, how it should be measured and the effect of risk on the rate of return required by investors. These issues are discussed in this chapter using the framework of portfolio theory, which shows how investors can maximize the expected return on a portfolio of risky assets for a given level of risk. The relationship between risk and expected return is first described by the capital asset pricing model...

...beta of 1.6 and a
risk-free asset. How much should you invest in the risk-free asset?
a. $0
b. $140
c. $200
d. $320
e. $400
ANALYZING A PORTFOLIO
d 59. You have a $1,000 portfolio which is invested in stocks A and B plus a risk-free asset.
$400 is invested in stock A. Stock A has a beta of 1.3 and stock B has a beta of .7.
How much needs to be invested in stock B if you want a portfolio beta of .90?
a. $0
b. $268
c. $482
d. $543
e. $600
EXPECTED RETURN
c 60. You recently purchased a stock that is expected to earn 12 percent in a booming economy, 8 percent in a normal economy and lose 5 percent in a recessionary economy. There is a 15 percent probability of a boom, a 75 percent chance of a normal economy, and a 10 percent chance of a recession. What is your expected rate of return on this stock?
a. 5.00 percent
b. 6.45 percent
c. 7.30 percent
d. 7.65 percent
e. 8.30 percent
EXPECTED RETURN
a 61. The Inferior Goods Co. stock is expected to earn 14 percent in a recession, 6 percent in a normal economy, and lose 4 percent in a booming economy. The probability of a boom is 20 percent while the probability of a normal economy is 55 percent and the chance of a recession is 25 percent. What is the expected rate of return on this stock?
a. 6.00 percent
b. 6.72 percent...

...Risk and Return: Portfolio Theory and Asset Pricing Models
Portfolio Theory Capital Asset Pricing Model (CAPM)
Efficient frontier Capital Market Line (CML) Security Market Line (SML) Beta calculation
Arbitrage pricing theory Fama-French 3-factor model
Portfolio Theory
• Suppose Asset A has an expected return of 10 percent and a standard deviation of 20 percent. Asset B has an expected return of 16 percent and a standard deviation of 40 percent. If the correlation between A and B is 0.6, what are the expected return and standard deviation for a portfolio comprised of 30 percent Asset A and 70 percent Asset B?
Portfolio Expected Return
ˆ ˆ ˆ rP = w A rA + (1 - w A ) rB = 0.3( 0.1) + 0.7( 0.16) = 0.142 = 14.2%.
Portfolio Standard Deviation
2 2 2 s p = WAs A + (1 - WA ) 2 s B + 2WA (1 - WA ) r AB s A s B
= 0.32 ( 0.22 ) + 0.7 2 ( 0.4 2 ) + 2( 0.3)( 0.7 )( 0.4)( 0.2)( 0.4) = 0.309
Attainable Portfolios: rAB = 0.4
? AB = +0.4: Attainable Set of Risk/Return Combinations
20%
Expected return
15% 10% 5% 0% 0%
10%
20% Risk, ? p
30%
40%
Attainable Portfolios: rAB = +1
? AB = +1.0: Attainable Set of Risk/Return Combinations 20%
Expected return
15% 10% 5% 0% 0% 10% 20% Risk, ? p 30% 40%
Attainable Portfolios: rAB = -1
? AB = -1.0:...

...the context of a portfolio, the risk of an asset is divided into two parts: diversifiable risk (unsystematic risk) and market risk (systematic risk). Diversifiable risk arises from company-specific factors and hence can be washed away through diversification. Market risk stems from general market movements and hence cannot be diversified away. For a diversified investor what matters is the market risk and not the diversifiable risk. (4)In general, investors are risk-averse. So, they want to be compensated for bearing market risk. In a well-ordered market there is a linear relationship between market risk and expected return. (1) RISK AND RETURN OF A SINGLE ASSET: Capital gains/ loss yield Current Yield Rate of Return=[Annual income/Beginning price]+[{Ending price-Beginning price}/ Beginning price] OR Total return = Dividend + Capital gain=
Rate of return Dividend yield Capital gain yield R1 DIV1 P1 P DIV1 P P 0 0 1 P P P 0 0 0
(2) PROBABILITY DISTRIBUTION AND EXPECTED RATE OF RETURN: E(R)=∑(i=1 to n)=p(i) *R(i), where, E(R)=expected return, n=number of possible outcomes, p(i)=probability associated with R(i), R(i)=return for the ith possible outcome....

...Risk and Return -II
PGDM/MMS- SEM-II
PROF. V. RAMACHANDRAN
FACULTY- SIESCOMS , NERUL
1
PORTFOLIOS & RISK
What is an Investment Portfolio
A group of Assets that is owned by an
Investor
Single Security is riskier than Investing in a
Portfolio.
Portfolio may contain- Equity Capital, Bonds ,
Real Estate, Savings Accounts, Bullion,
Collectibles etc.
In other words the Investor does not put all
his eggs in to one Basket.
2
Diversification –Risk Reduction
Let us assume you put your money equally into the
stocks of two companies Banlight Limited, a
manufacturer of sunglasses and Varsha Limited, a
manufacturer of rain coats.
If the monsoons are above average in a particular
year, the earnings of Varsha Limited would be up
leading to an increase in its share price and
returns to shareholders.
On the other hand, the earnings of Banlight would
be on the decline, leading to a corresponding decline
in the share prices and investor's returns.
If there is a prolonged summer the situation would
3
be just the opposite.
Diversification –Risk Reduction
While the return on each individual stock might
vary quite a bit depending on the weather but the
return on your portfolio (50% Banlight and 50%
Varsha stocks) could be quite stable because the
decline in one will be offset by the increase in the
other. In fact, at least in theory, the...

...Powerline Network Corporation—Case Two: Risk and Return
Thomas Calderone, CJ Anderson, and Megan Wegener
FIN 480: Finance Capstone Course
Professor Randy Lewis
Spring Arbor University
February 7, 2013
Powerline Network Corporation: Risk and Return
Introduction
The topics of risk and return are crucial to financial management because it allows a company to maximize stock value—in whichrisk is a determinant value, the rate of return in which investors require on various types of securities depends on their individual risks; and common and preferred stocks, bonds, and mutual funds are use for multiple things—401 K plans, for example— and each incur a certain amount of risk that are inherent to the type of investment. It is also important to note that creating optimal portfolios vary from investor to investor and depend greatly on age, risk tolerance, and other characteristics unique to investors. The issues discussed in this case all refer back to these fundamentals of risk and return and dig in deep to what the PNC directors need to learn and focus on.
Issue One: Standard Deviation and Expected Return
The following assets will be evaluated on riskiness according to the calculations of expected returns, standard deviations, and coefficients of variations....