Chapter 11 introduces you to risk and return. 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. | Risk and Return Chapter 11 Key Concepts and Skills 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 11- Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & Jordan Slides prepared by Rowan Trayler Chapter Outline Expected Returns and Variances Portfolios Announcements, Surprises and Expected Returns Risk: Systematic and Unsystematic Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital: A Preview 11- Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & Jordan Slides prepared by Rowan Trayler Expected Returns 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 11- Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & Jordan Slides prepared by Rowan Trayler Use the following example to illustrate the mathematical nature of expected returns: Consider a game where you toss a fair coin: If it is Heads then student A pays student B $1. If it is Tails then student B pays student A $1. Most students will remember from their statistics that the expected value is $0 (=.5(1) + .5(-1)). That means that if the game is played over and over then each student should expect to break-even. However, if the game is only played once, then one student will win $1 and one will lose $1. Example: Expected Returns Suppose you have predicted the following returns for shares C and T in three possible states of nature. What are the expected returns? State Probability C T Boom Normal . | Risk and Return Chapter 11 Key Concepts and Skills 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 11- Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & Jordan Slides prepared by Rowan Trayler Chapter Outline Expected Returns and Variances Portfolios Announcements, Surprises and Expected Returns Risk: Systematic and Unsystematic Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital: A Preview 11- Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & Jordan Slides prepared by Rowan Trayler Expected Returns Expected returns are based on the probabilities of possible outcomes In this context, “expected” means average if the .
