Analysis of Risk and Return

Topics: Capital asset pricing model, Modern portfolio theory, Risk in finance Pages: 42 (3824 words) Published: October 19, 2014
Chapter 8
Analysis of Risk and
Return

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Introduction

This chapter develops the risk-return
relationship for individual projects
(investments) and a portfolio of projects.

The principles can also be applied to
securities.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2

Meaning and Measurement of Risk

Risk

The possibility that actual cash flows will be
different from forecasted cash flows

Alternate definition: The possibility that
actual cash flows will be below the
forecasted cash flows.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3

Meaning and Measurement of Risk

Probability Distributions

Probability

The percentage change that a particular outcome
will occur

Probability Distribution

Indicates the percentage change of occurrence of
each of the possible outcomes

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4

Meaning and Measurement of Risk

Probability Distribution:

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5

Meaning and Measurement of Risk

Probability Distributions

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6

Meaning and Measurement of Risk

Expected Value

n
ˆ =  rj ×pj
r
j =1

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7

D8-1 What is the expected rate of return for a stock that has the following probability distribution for expected price and expected rate of return? Assume that the company will not pay dividends during the year.

Price
\$75
\$80
\$85
\$90

ˆ
r 

Rate of return
-12%
0%
+16%
+25%

Probability
0.20
0.25
0.35
0.20

n

r p
j 1

j

j

where n = 4 for 4 states of the economy

ˆ
r   -12.0  0.20    0.0  0.25   16.0  0.35    25.0  0.20   8.20

8.20%

8

Meaning and Measurement of Risk

Standard Deviation
n

2

ˆ
σ =  rj - r p j

j =1

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9

D8-2 What is the standard deviation of return for a stock that has the following probability distribution for expected price and expected rate of return? Assume that the company will not pay dividends during the year. The expected rate of return for this stock is 8.20%. (In a problem of this type on an exam, the expected rate of return would be given. You would not use the answer from a previous problem on expected return.) Price

\$75
\$80
\$85
\$90

 

Rate of return
-12%
0%
+16%
+25%

Probability
0.20
0.25
0.35
0.20

  rj - rˆ  p j
n

2

j 1

   -12.0 - 8.2   0.20    0.0 - 8.2   0.25   16.0 - 8.2   0.35    25.0 - 8.2   0.20   2

2

2

2

  13.27%

10

1
2

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11

Meaning and Measurement of Risk

Normal Probability Distribution