The Meaning and Measurement of Risk and Return
Learning Objectives
LO1 Define and measure the expected rate of return of an individual investment.
LO2 Define and measure the riskiness of an individual investment.
LO3 Compare the historical relationship between risk and rates of return in the capital markets.
LO4 Explain how diversifying investments affects the riskiness and expected rate of return of a portfolio or combination of assets.
LO5 Explain the relationship between an investor’s required rate of return on an investment and the riskiness of the investment.
Expected Return Defined and Measured
Risk Defined and Measured
Rates of Return: The Investor’s Experience
Risk and Diversification
The Investor’s Required Rate of Return
On Wednesday, February 13th we were joined by Jon Kazarian, Director of Business Development at Windham Labs, for a conversation on Portfolio Construction and Evaluation.
- Portfolio theory deals with constructing portfolios to maximize return for a given level of risk.
- Diversification reduces unsystematic risk but not all risk. Efficient portfolios provide the lowest risk for a given return.
- Beta measures the systematic risk of an asset relative to the market. A beta of 1 means the asset has the same volatility as the market.
The document discusses key concepts related to risk and return, including:
1) It defines risk as the uncertainty surrounding investment returns, and return as the total gain or loss on an investment. It also defines a portfolio as a group of assets.
2) It explains that diversification across different asset classes can reduce overall risk without significantly reducing expected returns, by offsetting losses and gains across assets.
3) It introduces the Capital Asset Pricing Model (CAPM), which defines the relationship between an asset's expected return and its systematic risk (beta). The CAPM states that the expected return is equal to the risk-free rate plus the asset's beta multiplied by the market risk premium.
This document discusses volatility controlled investing strategies for defined benefit and defined contribution pension plans. It begins with an overview of the challenges pension plans face in generating returns while managing downside risk. It then provides examples of how volatility control strategies work by varying equity market exposure in response to changing volatility levels. Key benefits of volatility control for pension plans include downside protection, lower costs compared to other protection strategies, and better risk-adjusted returns than passive equity exposure. The document also addresses common questions about volatility control and provides references for further reading.
This document provides an overview of capital structure. It defines sources of capital including equity and debt capital. It discusses the costs of equity, debt, and preferred shares. It introduces the weighted average cost of capital (WACC) and how it is used to determine a firm's target capital structure. The document also covers financial leverage and how it impacts earnings per share, return on equity, and risk. Break-even analysis and operating leverage are also summarized.
Financial engineering involves designing and implementing innovative financial instruments and processes to solve problems in finance. It applies theoretical finance and computer modeling to make pricing, hedging, trading and portfolio management decisions. Financial engineers bundle and unbundle securities to maximize profits using various asset classes. They are prepared for careers in areas like corporate finance, investments, and financial markets.
On Thursday, April 27th, 2017, we heard from Windham's own client consultant, Jon Kazarian about best methods and practices for the portfolio construction and evaluation process.
The document discusses risk and return in investments. It defines risk as the possibility of loss or variability in returns. It notes that risk and return are positively correlated, so higher risk investments like stocks generally offer higher returns than lower risk ones like bonds. It identifies two main components of risk: systematic risk that affects the overall market and unsystematic risk that is specific to a particular company. Common types of systematic risk include market risk, interest rate risk and inflation risk, while business and financial risk are examples of unsystematic risk. The document also provides examples of how to calculate expected returns, standard deviation of returns as a risk measure, and real rates of return adjusted for inflation.
On Wednesday, February 13th we were joined by Jon Kazarian, Director of Business Development at Windham Labs, for a conversation on Portfolio Construction and Evaluation.
- Portfolio theory deals with constructing portfolios to maximize return for a given level of risk.
- Diversification reduces unsystematic risk but not all risk. Efficient portfolios provide the lowest risk for a given return.
- Beta measures the systematic risk of an asset relative to the market. A beta of 1 means the asset has the same volatility as the market.
The document discusses key concepts related to risk and return, including:
1) It defines risk as the uncertainty surrounding investment returns, and return as the total gain or loss on an investment. It also defines a portfolio as a group of assets.
2) It explains that diversification across different asset classes can reduce overall risk without significantly reducing expected returns, by offsetting losses and gains across assets.
3) It introduces the Capital Asset Pricing Model (CAPM), which defines the relationship between an asset's expected return and its systematic risk (beta). The CAPM states that the expected return is equal to the risk-free rate plus the asset's beta multiplied by the market risk premium.
This document discusses volatility controlled investing strategies for defined benefit and defined contribution pension plans. It begins with an overview of the challenges pension plans face in generating returns while managing downside risk. It then provides examples of how volatility control strategies work by varying equity market exposure in response to changing volatility levels. Key benefits of volatility control for pension plans include downside protection, lower costs compared to other protection strategies, and better risk-adjusted returns than passive equity exposure. The document also addresses common questions about volatility control and provides references for further reading.
This document provides an overview of capital structure. It defines sources of capital including equity and debt capital. It discusses the costs of equity, debt, and preferred shares. It introduces the weighted average cost of capital (WACC) and how it is used to determine a firm's target capital structure. The document also covers financial leverage and how it impacts earnings per share, return on equity, and risk. Break-even analysis and operating leverage are also summarized.
Financial engineering involves designing and implementing innovative financial instruments and processes to solve problems in finance. It applies theoretical finance and computer modeling to make pricing, hedging, trading and portfolio management decisions. Financial engineers bundle and unbundle securities to maximize profits using various asset classes. They are prepared for careers in areas like corporate finance, investments, and financial markets.
On Thursday, April 27th, 2017, we heard from Windham's own client consultant, Jon Kazarian about best methods and practices for the portfolio construction and evaluation process.
The document discusses risk and return in investments. It defines risk as the possibility of loss or variability in returns. It notes that risk and return are positively correlated, so higher risk investments like stocks generally offer higher returns than lower risk ones like bonds. It identifies two main components of risk: systematic risk that affects the overall market and unsystematic risk that is specific to a particular company. Common types of systematic risk include market risk, interest rate risk and inflation risk, while business and financial risk are examples of unsystematic risk. The document also provides examples of how to calculate expected returns, standard deviation of returns as a risk measure, and real rates of return adjusted for inflation.
The document discusses various approaches to asset and liability management (ALM), with a focus on liquidity risk management. It proposes using multiple metrics to measure liquidity risk, including the loan-to-deposit ratio, 1-week and 1-month liquidity ratios, a cumulative liquidity model, an intercompany lending report, and a liquidity risk factor. These metrics provide different insights into a bank's self-sufficiency, exposure to roll risk, potential stress points, and daily funding needs from both structural and forward-looking perspectives. The document emphasizes examining liquidity risk at the country, legal entity, and group levels with appropriate limits and assumptions.
The document outlines the process of portfolio management across four parts. It discusses establishing investment objectives and policies, constructing a portfolio using diversification and asset allocation strategies, maintaining the portfolio through active or passive management, and protecting it through hedging strategies and derivatives. Performance is evaluated based on return and risk metrics to ensure objectives are met. Fiduciary duties require managers to act in clients' best interests when overseeing their money and investments. The portfolio process aims to balance risks and returns through various economic conditions.
This document provides an overview of Redington, an investment consulting firm, and its manager research process. Redington divides investments into seven steps according to liquidity and risk, and evaluates managers according to four filters: expected returns, risk assessment, relative value, and implementation challenges. The manager research team uses eVestment to monitor over 40,000 strategies and conducts regular searches across asset classes including LDI, equities, credit, and alternative investments like secured leases. Redington aims to help pension clients achieve full funding through its seven-step framework and ongoing manager due diligence.
In this presentation, we review methods and best practices for the portfolio construction and evaluation process. The presentation covers risk and return estimation, mean-variance optimization as well as techniques for analyzing exposure to loss and wealth potential.
This document discusses capital budgeting and the capital budgeting process. It covers key steps like generating investment ideas, analyzing proposals using techniques like net present value, internal rate of return, and payback period. It also discusses types of capital projects, rules of analysis, and definitions. The second half covers cost of capital, including costs of equity, debt, and preferred stock. It provides examples of calculating these costs and weighted average cost of capital (WACC), which weights the costs based on the firm's target capital structure.
The document outlines the process of portfolio management over 6 steps: 1) Learn basic finance principles 2) Set objectives 3) Formulate strategy 4) Plan for revisions 5) Evaluate performance 6) Protect the portfolio. It discusses traditional investments like security analysis and portfolio construction. Portfolio management aims to reduce risk rather than increase returns. The manager's job is to create the best collection for each client per their unique needs within the constraints of the investment policy statement.
The document outlines the process of portfolio management over 6 steps: 1) Learn basic finance principles 2) Set objectives 3) Formulate strategy 4) Plan for revisions 5) Evaluate performance 6) Protect the portfolio. It discusses traditional investments like security analysis and portfolio construction. Portfolio management aims to reduce risk rather than increase returns. The manager's job is to create the best collection for each client per their unique needs within the constraints of the investment policy statement.
The document discusses international diversification and its benefits. It explains that international diversification reduces total portfolio risk because securities in different countries tend to have low correlations. While international investments carry additional risks like foreign exchange risk, a portfolio manager can decrease overall risk by including global securities that behave differently than domestic holdings. The document also reviews several international investment concepts like purchasing power parity and covered interest arbitrage.
The document discusses international diversification and its benefits. It explains that international diversification reduces total portfolio risk because securities in different countries tend to have low correlations. While international investments carry additional risks like foreign exchange risk, a portfolio manager can decrease overall risk by including global securities that behave differently than domestic holdings. The document also reviews several international investment concepts like purchasing power parity and covered interest arbitrage.
Asset Allocation for Specific Client GoalsWindham Labs
On Wednesday, January 24th, we heard from Senior Client Consultant Jon Kazarian on how to tailor a portfolio to meet the specific investment goals of a client.
The document provides an overview of the process of portfolio management. It discusses 6 key steps: 1) learning basic finance principles, 2) setting objectives, 3) formulating an investment strategy, 4) planning for revisions, 5) evaluating performance, and 6) protecting the portfolio. The document also outlines 4 parts that will be covered: background and principles, portfolio construction, management, and protection/contemporary issues. Traditional investments like security analysis and portfolio management are introduced.
The document provides an overview of the process of portfolio management. It discusses 6 key steps: 1) learning basic finance principles, 2) setting objectives, 3) formulating an investment strategy, 4) planning for revisions, 5) evaluating performance, and 6) protecting the portfolio. The document also outlines 4 parts that will be covered: background and principles, portfolio construction, management, and protection. It provides examples of different investment types, strategies for construction and maintenance, and tools for evaluation and risk management.
The document provides an overview of the process of portfolio management. It discusses 6 key steps: 1) learning basic finance principles, 2) setting objectives, 3) formulating an investment strategy, 4) planning for revisions, 5) evaluating performance, and 6) protecting the portfolio. The document also outlines 4 parts that will be covered: background and principles, portfolio construction, management, and protection/contemporary issues. Traditional investments like security analysis and portfolio management are introduced.
The document provides an introduction to a course on investments. It outlines the purpose of learning to manage money through investments to maximize benefits. It discusses learning about available investment alternatives and developing an analytical approach. The course will cover topics such as risk and return measurement, modern portfolio theory, equity and debt analysis, portfolio optimization and evaluation. It will use a mix of theory, practical applications and Microsoft Excel. The course will have 30 classes covering these topics and references various investment textbooks and notes.
Multinational cost and capital structureNits Kedia
The document discusses how multinational corporations determine their cost of capital and establish optimal capital structures. It explains that an MNC's cost of capital may differ from domestic firms due to their size, access to international markets, diversification across countries, and exposure to exchange rate and country risks. The cost of capital also varies by country based on interest rates, risk premiums, and tax laws. An MNC considers these corporate and country characteristics when deciding how much debt and equity to use in different subsidiaries to minimize its overall cost of capital.
The document discusses how multinational corporations determine their cost of capital and establish optimal capital structures. It explains that an MNC's cost of capital may differ from domestic firms due to their size, access to international markets, diversification across countries, and exposure to exchange rate and country risks. The cost of capital also varies by country based on interest rates, risk premiums, and tax laws. An MNC considers these corporate and country characteristics when deciding how much debt and equity to use in different subsidiaries to minimize its overall cost of capital.
Repositioning Assets for Buyouts & Buy-ins from Gilts to InfrastructureRedington
The document outlines a seven step process for pension funds to reposition assets and achieve full funding. Step 1 establishes clear funding objectives and risk budgets. Step 2 involves setting up a liability driven investment hub to manage interest rate and inflation risk. Steps 3-6 detail designing an efficient investment strategy that includes liquid and illiquid credit, as well as alpha and beta strategies. Step 7 focuses on ongoing monitoring to track progress towards objectives. The overall goal is to generate sufficient returns to meet required returns and reach full funding targets through strategic asset allocation and risk management.
Repositioning Assets for Buyouts and Buy-insRedington
The document outlines a seven step process for pension funds to reposition assets and achieve full funding. Step 1 establishes clear funding objectives and risk metrics. Step 2 involves setting up a liability driven investment hub to manage interest rate and inflation risk. Steps 3-6 detail designing an efficient investment strategy, including liquid and illiquid credit, and alpha and beta strategies. Step 7 focuses on ongoing monitoring to track progress against objectives. The overall goal is to generate sufficient returns to meet required returns and reach full funding targets through strategic asset allocation and risk management.
This document discusses concepts of risk and return in investment. It defines return as the basic motivating force and principal reward in investment. There are two types of return - realized return which has been earned, and expected return which is anticipated to be earned in the future. Risk refers to the possibility that the actual return may differ from the expected return. There are two main types of risk - systematic/non-diversifiable risk due to overall market factors, and unsystematic/diversifiable risk that is firm-specific. Required return from an investment is determined by the risk-free rate, expected inflation rate, and risk premium. Various measures like variance and standard deviation are used to quantify investment risk.
This document discusses various methods for analyzing risk in capital budgeting decisions, including sensitivity analysis and scenario analysis. It begins by defining risk and different sources of uncertainty that can influence a project's future cash flows. It then covers measuring risk through tools like standard deviation, beta, and the certainty equivalent method. Sensitivity analysis and scenario analysis are presented as ways to assess how changes in assumptions may impact project outcomes. Sensitivity analysis involves changing one variable at a time, while scenario analysis considers alternative outcomes based on defined scenarios like best, worst, and base cases. The document provides examples of applying these risk analysis techniques in capital budgeting evaluations.
Top 10 Free Accounting and Bookkeeping Apps for Small BusinessesYourLegal Accounting
Maintaining a proper record of your money is important for any business whether it is small or large. It helps you stay one step ahead in the financial race and be aware of your earnings and any tax obligations.
However, managing finances without an entire accounting staff can be challenging for small businesses.
Accounting apps can help with that! They resemble your private money manager.
They organize all of your transactions automatically as soon as you link them to your corporate bank account. Additionally, they are compatible with your phone, allowing you to monitor your finances from anywhere. Cool, right?
Thus, we’ll be looking at several fantastic accounting apps in this blog that will help you develop your business and save time.
The Steadfast and Reliable Bull: Taurus Zodiac Signmy Pandit
Explore the steadfast and reliable nature of the Taurus Zodiac Sign. Discover the personality traits, key dates, and horoscope insights that define the determined and practical Taurus, and learn how their grounded nature makes them the anchor of the zodiac.
The document discusses various approaches to asset and liability management (ALM), with a focus on liquidity risk management. It proposes using multiple metrics to measure liquidity risk, including the loan-to-deposit ratio, 1-week and 1-month liquidity ratios, a cumulative liquidity model, an intercompany lending report, and a liquidity risk factor. These metrics provide different insights into a bank's self-sufficiency, exposure to roll risk, potential stress points, and daily funding needs from both structural and forward-looking perspectives. The document emphasizes examining liquidity risk at the country, legal entity, and group levels with appropriate limits and assumptions.
The document outlines the process of portfolio management across four parts. It discusses establishing investment objectives and policies, constructing a portfolio using diversification and asset allocation strategies, maintaining the portfolio through active or passive management, and protecting it through hedging strategies and derivatives. Performance is evaluated based on return and risk metrics to ensure objectives are met. Fiduciary duties require managers to act in clients' best interests when overseeing their money and investments. The portfolio process aims to balance risks and returns through various economic conditions.
This document provides an overview of Redington, an investment consulting firm, and its manager research process. Redington divides investments into seven steps according to liquidity and risk, and evaluates managers according to four filters: expected returns, risk assessment, relative value, and implementation challenges. The manager research team uses eVestment to monitor over 40,000 strategies and conducts regular searches across asset classes including LDI, equities, credit, and alternative investments like secured leases. Redington aims to help pension clients achieve full funding through its seven-step framework and ongoing manager due diligence.
In this presentation, we review methods and best practices for the portfolio construction and evaluation process. The presentation covers risk and return estimation, mean-variance optimization as well as techniques for analyzing exposure to loss and wealth potential.
This document discusses capital budgeting and the capital budgeting process. It covers key steps like generating investment ideas, analyzing proposals using techniques like net present value, internal rate of return, and payback period. It also discusses types of capital projects, rules of analysis, and definitions. The second half covers cost of capital, including costs of equity, debt, and preferred stock. It provides examples of calculating these costs and weighted average cost of capital (WACC), which weights the costs based on the firm's target capital structure.
The document outlines the process of portfolio management over 6 steps: 1) Learn basic finance principles 2) Set objectives 3) Formulate strategy 4) Plan for revisions 5) Evaluate performance 6) Protect the portfolio. It discusses traditional investments like security analysis and portfolio construction. Portfolio management aims to reduce risk rather than increase returns. The manager's job is to create the best collection for each client per their unique needs within the constraints of the investment policy statement.
The document outlines the process of portfolio management over 6 steps: 1) Learn basic finance principles 2) Set objectives 3) Formulate strategy 4) Plan for revisions 5) Evaluate performance 6) Protect the portfolio. It discusses traditional investments like security analysis and portfolio construction. Portfolio management aims to reduce risk rather than increase returns. The manager's job is to create the best collection for each client per their unique needs within the constraints of the investment policy statement.
The document discusses international diversification and its benefits. It explains that international diversification reduces total portfolio risk because securities in different countries tend to have low correlations. While international investments carry additional risks like foreign exchange risk, a portfolio manager can decrease overall risk by including global securities that behave differently than domestic holdings. The document also reviews several international investment concepts like purchasing power parity and covered interest arbitrage.
The document discusses international diversification and its benefits. It explains that international diversification reduces total portfolio risk because securities in different countries tend to have low correlations. While international investments carry additional risks like foreign exchange risk, a portfolio manager can decrease overall risk by including global securities that behave differently than domestic holdings. The document also reviews several international investment concepts like purchasing power parity and covered interest arbitrage.
Asset Allocation for Specific Client GoalsWindham Labs
On Wednesday, January 24th, we heard from Senior Client Consultant Jon Kazarian on how to tailor a portfolio to meet the specific investment goals of a client.
The document provides an overview of the process of portfolio management. It discusses 6 key steps: 1) learning basic finance principles, 2) setting objectives, 3) formulating an investment strategy, 4) planning for revisions, 5) evaluating performance, and 6) protecting the portfolio. The document also outlines 4 parts that will be covered: background and principles, portfolio construction, management, and protection/contemporary issues. Traditional investments like security analysis and portfolio management are introduced.
The document provides an overview of the process of portfolio management. It discusses 6 key steps: 1) learning basic finance principles, 2) setting objectives, 3) formulating an investment strategy, 4) planning for revisions, 5) evaluating performance, and 6) protecting the portfolio. The document also outlines 4 parts that will be covered: background and principles, portfolio construction, management, and protection. It provides examples of different investment types, strategies for construction and maintenance, and tools for evaluation and risk management.
The document provides an overview of the process of portfolio management. It discusses 6 key steps: 1) learning basic finance principles, 2) setting objectives, 3) formulating an investment strategy, 4) planning for revisions, 5) evaluating performance, and 6) protecting the portfolio. The document also outlines 4 parts that will be covered: background and principles, portfolio construction, management, and protection/contemporary issues. Traditional investments like security analysis and portfolio management are introduced.
The document provides an introduction to a course on investments. It outlines the purpose of learning to manage money through investments to maximize benefits. It discusses learning about available investment alternatives and developing an analytical approach. The course will cover topics such as risk and return measurement, modern portfolio theory, equity and debt analysis, portfolio optimization and evaluation. It will use a mix of theory, practical applications and Microsoft Excel. The course will have 30 classes covering these topics and references various investment textbooks and notes.
Multinational cost and capital structureNits Kedia
The document discusses how multinational corporations determine their cost of capital and establish optimal capital structures. It explains that an MNC's cost of capital may differ from domestic firms due to their size, access to international markets, diversification across countries, and exposure to exchange rate and country risks. The cost of capital also varies by country based on interest rates, risk premiums, and tax laws. An MNC considers these corporate and country characteristics when deciding how much debt and equity to use in different subsidiaries to minimize its overall cost of capital.
The document discusses how multinational corporations determine their cost of capital and establish optimal capital structures. It explains that an MNC's cost of capital may differ from domestic firms due to their size, access to international markets, diversification across countries, and exposure to exchange rate and country risks. The cost of capital also varies by country based on interest rates, risk premiums, and tax laws. An MNC considers these corporate and country characteristics when deciding how much debt and equity to use in different subsidiaries to minimize its overall cost of capital.
Repositioning Assets for Buyouts & Buy-ins from Gilts to InfrastructureRedington
The document outlines a seven step process for pension funds to reposition assets and achieve full funding. Step 1 establishes clear funding objectives and risk budgets. Step 2 involves setting up a liability driven investment hub to manage interest rate and inflation risk. Steps 3-6 detail designing an efficient investment strategy that includes liquid and illiquid credit, as well as alpha and beta strategies. Step 7 focuses on ongoing monitoring to track progress towards objectives. The overall goal is to generate sufficient returns to meet required returns and reach full funding targets through strategic asset allocation and risk management.
Repositioning Assets for Buyouts and Buy-insRedington
The document outlines a seven step process for pension funds to reposition assets and achieve full funding. Step 1 establishes clear funding objectives and risk metrics. Step 2 involves setting up a liability driven investment hub to manage interest rate and inflation risk. Steps 3-6 detail designing an efficient investment strategy, including liquid and illiquid credit, and alpha and beta strategies. Step 7 focuses on ongoing monitoring to track progress against objectives. The overall goal is to generate sufficient returns to meet required returns and reach full funding targets through strategic asset allocation and risk management.
This document discusses concepts of risk and return in investment. It defines return as the basic motivating force and principal reward in investment. There are two types of return - realized return which has been earned, and expected return which is anticipated to be earned in the future. Risk refers to the possibility that the actual return may differ from the expected return. There are two main types of risk - systematic/non-diversifiable risk due to overall market factors, and unsystematic/diversifiable risk that is firm-specific. Required return from an investment is determined by the risk-free rate, expected inflation rate, and risk premium. Various measures like variance and standard deviation are used to quantify investment risk.
This document discusses various methods for analyzing risk in capital budgeting decisions, including sensitivity analysis and scenario analysis. It begins by defining risk and different sources of uncertainty that can influence a project's future cash flows. It then covers measuring risk through tools like standard deviation, beta, and the certainty equivalent method. Sensitivity analysis and scenario analysis are presented as ways to assess how changes in assumptions may impact project outcomes. Sensitivity analysis involves changing one variable at a time, while scenario analysis considers alternative outcomes based on defined scenarios like best, worst, and base cases. The document provides examples of applying these risk analysis techniques in capital budgeting evaluations.
Top 10 Free Accounting and Bookkeeping Apps for Small BusinessesYourLegal Accounting
Maintaining a proper record of your money is important for any business whether it is small or large. It helps you stay one step ahead in the financial race and be aware of your earnings and any tax obligations.
However, managing finances without an entire accounting staff can be challenging for small businesses.
Accounting apps can help with that! They resemble your private money manager.
They organize all of your transactions automatically as soon as you link them to your corporate bank account. Additionally, they are compatible with your phone, allowing you to monitor your finances from anywhere. Cool, right?
Thus, we’ll be looking at several fantastic accounting apps in this blog that will help you develop your business and save time.
The Steadfast and Reliable Bull: Taurus Zodiac Signmy Pandit
Explore the steadfast and reliable nature of the Taurus Zodiac Sign. Discover the personality traits, key dates, and horoscope insights that define the determined and practical Taurus, and learn how their grounded nature makes them the anchor of the zodiac.
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risk and return student.ppt
1. Principles of Finance
o Lecture 6
o Risk and Return
o 2022
SMS Principles of Finance - 22 Prof. Abdelgadir 1
8/11/2022
2. Learning objectives
1. States and nature of investment decision making
2. Meaning of risk and return
3. Assessing and measuring the expected return and
risk of a single asset.
4. Discuss the measurement of return and standard
deviation for a portfolio
5. Review the two types of risk and diversification
6. Measurement of systematic risk
7. Explain the capital asset pricing model (CAPM)
2
8/11/2022 SMS Principles of Finance - 22 Prof. Abdelgadir
3. States/Nature of investment Decision Making
• Certainty: an investment decision leads to a specific outcome
and that outcome is known with certainty: Perfect
information and knowledge
• Risk: an investment decision leads to a number of outcomes
we do not know which one will happen but we can estimate
and know the probability of each one happening: Partial
information/knowledge
• Uncertainty: an investment decision leads to a number of
outcomes we do not know which one will happen and we do
not know the probability of occurrence: complete ignorance.
SMS Principles of Finance - 22 Prof. Abdelgadir 3
8/11/2022
5. Example 1
• Anas wishes to determine the returns on two of his machines
C & D. C 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. D 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
SMS Principles of Finance - 22 Prof. Abdelgadir 5
8/11/2022
6. Example 2
• An investor purchased a share last year for
120 pounds and at the end of the year
received 15 pounds as dividend and sold the
share for 117 pounds. What is his return from
this share?
• Return = 15 + (117-120) = 10%
• 120
8/11/2022 SMS Principles of Finance - 22 Prof. Abdelgadir 6
7. Example3- Calculating Returns
• You bought a stock for $35 and you received
dividends of $1.25. The stock is now selling for
$40.
– What is your dollar return?
• Dollar return = 1.25 + (40 – 35) = $6.25
– What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%
• Total percentage return = 6.25 / 35 = 17.86%
SMS Principles of Finance - 22 Prof. Abdelgadir
8/11/2022 7
8. Risk Defined
• In the context of business and finance, risk is defined as the
chance of suffering a financial loss.
• Assets 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.
• In case of risk we talk expected return and not actual return.
• Total risk is measured by the variance or the standard
deviation
8/11/2022 SMS Principles of Finance - 22 Prof. Abdelgadir 8
9. Expected Returns: Single Asset
• Expected returns are based on the
probabilities of possible outcomes
• In this context, “expected” means average if
the process is repeated many times
• The “expected” return does not even have to
be a possible return
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10. Example: Expected Returns: Single Asset
• Suppose you have predicted the following returns for stocks C and
T in three possible states of nature. What are the expected
returns?
– State Probability C T
– Boom 0.3 15 25
– Normal 0.5 10 20
– Recession ??? 2 1
• RC = .3(15) + .5(10) + .2(2) = 9.99%
• RT = .3(25) + .5(20) + .2(1) = 17.7%
• If the risk-free rate is 6.15%, what is the risk premium?
• Stock C: 9.99 – 6.15 = 3.84%
• Stock T: 17.7 – 6.15 = 11.55%
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11. Variance and Standard Deviation: Single Asset
• Variance and standard deviation still measure
the volatility of returns
• Using unequal probabilities for the entire
range of possibilities
• Weighted average of squared deviations
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11
12. Example: Variance and Standard
Deviation
• Consider the previous example. What are the
variance and standard deviation for each stock?
• Stock C
– 2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29
– = 4.5
• Stock T
– 2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 = 74.41
– = 8.63
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13. Risk Measurement for a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure
of relative dispersion that is useful in
comparing risks of assets with differing
expected returns.
• CV = Standard Deviation/Expected Return
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14. Risk Measurement for a Single Asset:
Coefficient of Variation
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statistics Asset A Asset B
(1) Expected Return 12% 20%
(2) Standard Deviation 9% a 10%
(3) Coefficient of Variation (2)/(1) 0.75 0.50 a
a : Preferred asset using the given risk measure
15. Portfolios
• A portfolio is a collection of assets
• The return of a portfolio is measured by the
portfolio expected return
• The total risk of a portfolio is measured by the
standard deviation, just as with individual
assets
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16. Example: Portfolio Weights
• Suppose you have $ 20000 to invest and you
have purchased securities in the following
amounts. What are your portfolio weights in
each security?
– $2000 of A
– $5000 of B
– $4000 of C
– $9000of D
•A: 2000/20000 = 10%
•B: 5000/20000 = 25%
•C: 4000/20000 = 20%
•D: 9000/20000 = 45%
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17. Portfolio Expected Returns
• The expected return of a portfolio is the weighted
average of the expected returns for each asset in the
portfolio
• You can also find the expected return by finding the
portfolio return in each possible state and computing
the expected value as we did with individual
securities
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18. Example: Expected Portfolio
Returns
• Consider the portfolio weights computed previously.
If the individual stocks have the following expected
returns, what is the expected return for the
portfolio?
– A : 5 %
– B: 10%
– C: 12%
– D: 8 %
• E(RP) = 0.10(0.05) + 0.25(0.10) + 0.20(0.12) +
0.45(0.08) = 9%
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19. Example: Portfolio Variance (risk)
• Consider the following information
– Invest 50% of your money in Asset A
– State Probability A B
– Boom .4 30% -5%
– Bust .6 -10% 25%
• What are the expected return and standard
deviation for each asset?
• What are the expected return and standard
deviation for the portfolio?
Portfolio
12.5%
7.5%
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20. Portfolio Variance
• Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using
the same formula as for an individual asset
• Compute the portfolio variance and standard
deviation using the same formulas as for an
individual asset
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21. Portfolio Variance
If A and B are your only choices, what percent are you investing
in Asset B?
Asset A: E(RA) = .4(30) + .6(-10) = 6%
Asset B: E(RB) = .4(-5) + .6(25) = 13%
Variance(A) = .4(30-6)2 + .6(-10-6)2 = 384 Std. Dev.(A) = 19.6%
Variance(B) = .4(-5-13)2 + .6(25-13)2 = 216 Std. Dev.(B) = 14.7%
Portfolio return in boom = .5(30) + .5(-5) = 12.5
Portfolio return in bust = .5(-10) + .5(25) = 7.5
Expected return = .4(12.5) + .6(7.5) = 9.5 or .5(6) + .5(13) = 9.5
Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6 Standard
deviation = 2.45%
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22. Portfolio Variance
• Note that the variance is NOT equal to .5(384)
+ .5(216) = 300 and
• Standard deviation is NOT equal to .5(19.6) +
.5(14.7) = 17.17%
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23. Total Risk
• Total risk = systematic risk + unsystematic risk
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24. Systematic Risk
• Risk factors that affect a large number of
assets
• Also known as non-diversifiable risk or market
risk
• Includes such things as changes in GDP,
inflation, interest rates, etc.
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25. Unsystematic Risk
• Risk factors that affect a limited number of
assets
• Also known as unique risk and asset-specific
risk
• Includes such things as labor strikes, part
shortages, etc.
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26. Risk Measurement
• The standard deviation of returns is a measure
of total risk
• For well-diversified portfolios, unsystematic
risk is very small
• Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk
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27. Diversification
• Portfolio diversification is the investment in several
different asset classes or sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 internet stocks, you are
not diversified
• However, if you own 50 stocks that span 20 different
industries, then you are diversified
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28. The Principle of Diversification
• Diversification can reduce the variability of
returns without an equivalent reduction in
expected returns
• This reduction in risk arises because worse
than expected returns from one asset are
offset by better than expected returns from
another
• However, there is a minimum level of risk that
cannot be diversified away and that is the
systematic portion
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29. Measuring Systematic Risk
• How do we measure systematic risk?
• We use the beta coefficient to measure systematic risk
• Beta reflects the change in the stock price that results from
the change in the market price
• What does beta tell us?
– A beta of 1 implies the asset has the same systematic risk
as the overall market
– A beta < 1 implies the asset has less systematic risk than
the overall market
– A beta > 1 implies the asset has more systematic risk than
the overall market
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30. Total versus Systematic Risk
• Consider the following information:
Standard Deviation Beta
– Security C 20% 1.25
– Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher
expected return?
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31. Example: Portfolio Betas
• Consider the previous example with the following
four securities
– Security Weight Beta
– A 0.10 2.685
– B 0.25 0.195
– C 0.20 2.161
– D 0.45 2.434
• What is the portfolio beta?
• 0.10(2.685) + 0.25(.195) + 0.20(2.161) + 0.45(2.434)
= 1.845
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32. Beta and the Risk Premium
• Remember that the risk premium = expected
return – risk-free rate
• The higher the beta, the greater the risk
premium should be
• Can we define the relationship between the
risk premium and beta so that we can
estimate the expected return?
– YES!
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33. The Capital Asset Pricing Model
(CAPM)
• The capital asset pricing model defines the
relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can
use the CAPM to determine its expected
return
• This is true whether we are talking about
financial assets or physical assets
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34. Relationship Between Risk & Expected Return
Expected
return
)
(
β F
M
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i R
R
R
R
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F
R
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M
R
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35. Example - CAPM
• Consider the betas for each of the assets given
earlier. If the risk-free rate is 2.13% and the market
risk premium is 8.6%, what is the expected return for
each?
Security Beta Expected Return
A 2.685 2.13 + 2.685(8.6) = 25.22%
B 0.195 2.13 + 0.195(8.6) = 3.81%
C 2.161 2.13 + 2.161(8.6) = 20.71%
D 2.434 2.13 + 2.434(8.6) = 23.06%
13-35
36. Tutorial
1.The excess return required from a risky asset over that required from a risk-free asset is called
a. risk premium.
b. variance..
c. excess return.
d. average return.
2.The average squared difference between the actual return and the average return is called the:
a. volatility return.
b. variance.
c. standard deviation.
d. risk premium.
3.The standard deviation for a set of stock returns can be calculated as the:
a. positive square root of the average return.
b. average squared difference between the actual return and the average return.
c. positive square root of the variance.
d. average return divided by N minus one, where N is the number of returns.
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37. Tutorial
4- A year ago, you purchased 300 shares of IXC Technologies, Inc. stock at a price of $9.03 per share. The stock
pays an annual dividend of $.10 per share. Today, you sold all of your shares for $28.14 per share. What is your
total dollar return on this investment?
a. $5,703
b. $5,733
c. $5,753
d. $5,763
5- You purchased 200 shares of stock at a price of $36.72 per share. Over the last year, you have received total
dividend income of $322. What is the dividend yield?
a. 3.2 percent
b. 4.4 percent
c. 6.8 percent
d. 9.2 percent
6- You just sold 200 shares of Langley, Inc. stock at a price of $38.75 a share. Last year you paid $41.50 a share
to buy this stock. Over the course of the year, you received dividends totaling $1.64 per share. What is your
capital gain on this investment?
a. -$550
b. -$222
c. -$3
d. $550
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38. Tutorial
7- 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
8- Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. undiversifiable
c. market
d. unsystematic
9- You are comparing stock A to stock B. Given the following information, which one of these two stocks should
you prefer and why?
Rate of Return if
State of Probability of State Occurs
Economy State of Economy Stock A Stock B
Boom 60% 9% 15%
Recession 40% 4% -6%
a. Stock A; because it has an expected return of 7 percent and appears to be more risky.
b. Stock A; because it has a higher expected return and appears to be less risky than stock B.
c. Stock A; because it has a slightly lower expected return but appears to be significantly less risky than stock B.
d. Stock B; because it has a higher expected return and appears to be just slightly more risky than stock A.
e. Stock B; because it has a higher expected return and appears to be less risky than stock A.
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39. Tutorial
10- You own a portfolio with the following expected returns given the various states of the economy. What is the
overall portfolio expected return?
State of Probability of Rate of Return
Economy State of Economy if State Occurs
Boom 15% 18%
Normal 60% 11%
Recession 25% -10%
a. 6.3 percent
b. 6.8 percent
c. 7.6 percent
d. 10.0 percent
11- What is the portfolio variance if 30 percent is invested in stock S and 70 percent is invested in stock T?
State of Probability of Returns if State Occurs
Economy State of Economy Stock S Stock T
Boom 40% 12% 20%
Normal 60% 6% 4%
a. .002220
b. .004056
c. .006224
d. .008080
12- Your portfolio is comprised of 30 percent of stock X, 50 percent of stock Y, and 20 percent of stock Z. Stock X has a beta of .64,
stock Y has a beta of 1.48, and stock Z has a beta of 1.04. What is the beta of your portfolio?
a. 1.01
b. 1.05
c. 1.09
d. 1.14
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