After completing this unit, you should be able to: Know how to calculate expected returns, understand the impact of diversification, understand the systematic risk principle, understand the security market line, understand the risk-return trade-off. | Chapter 11 Lecture – Risk and Return Chapter 11 Lecture – Risk and Return Learning Objectives After studying this chapter, you should be able to: LO1 Calculate expected returns. LO2 Explain the impact of diversification. LO3 Define the systematic risk principle. LO4 Discuss the security market line and the risk-return trade-off. 11-1 11-2 What are Investment Returns? What is Investment Risk? Investment returns measure the financial results of an investment. Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk. Returns may be historical or prospective (anticipated). Returns can be expressed in: Dollar (or any other currency) terms. Percentage terms. What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? Risk-averse investors require higher rates of return to invest in higher-risk securities Dollar return:$ Received - $ Invested $1,100 - $1,000= $100. Percentage return:$ Return/$ Invested $100/$1,000 = = 10%. 3 4 11-3 1 11-4 Chapter 11 Lecture – Risk and Return Indifference Curves for Risk Adverse and RiskLoving Investors Expected Returns • Expected returns are based on the probabilities of possible outcomes E x p e c t e d n E ( R) pi Ri i 1 R e t u r n s Where: pi = the probability of state “i” occurring Ri = the expected return on an asset in state i Risk 11-5 11-6 Example: Expected Returns State (i) Recession Neutral Boom E(R) p(i) Probability distribution Stock X E(R) Stock A Stock B E(Ra) p(i) x E(Ra) E(Rb) p(i) x E(Rb) -20% 30% 15% 15% 35% -10% Stock Y n E ( R ) pi R i -20 i 1 0 15 50 Rate of return (%) Which stock is riskier? Why? 11-7 11-8 2 Chapter 11 Lecture – Risk and Return Variance and .
