FINANCE

Topic 5: Risk and Return

Learning Outcomes introduction to risk and return expected return and risk on individual asset expected return and risk on portfolio systematic and unsystematic risk diversification capital asset pricing model (CAPM) and the security market line

Risk and Return

M K Lai

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Introduction to Risk and Return finance can be complicated, but it can be reduced to three basic concepts

cash flows Risk and Return

time value of money risk and return

M K Lai

building blocks in finance Page 3

Basic Assumptions in Finance people are rational people prefer more wealth to less (higher expected return) people are risk averse investors require compensation (known as risk premium) for bearing risk positive relationship between risk and return
Risk and Return

M K Lai

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Basic Assumptions in Finance higher return reflects higher risk risk-adjusted return = risk-free rate + risk premium risk-free rate is estimated from the yield on government bond the higher the risk an investment, the higher is the risk premium

Risk and Return

M K Lai

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Risk and Return three issues to address how to measure return? how to measure risk? how to consider a tradeoff between risk and return? Risk and Return

M K Lai

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Return Measurement return is defined as total benefits in excess of initial investment total return interim income DT, e.g. dividends, coupons, rental income,… capital gain/loss (PT – PT-1): difference between current market value and original purchase price
Risk and Return

M K Lai

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Return Measurement dollar return: PT – PT-1 + DT rate of return: (PT – PT-1 + DT)/PT-1 where PT = current market value; PT-1 = original purchase price; DT = interim income received at T in the business finance, “return” usually refers to the rate of return
Risk and Return

M K Lai

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Example: Return Measurement
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