Risk and ReturnFINC 3610 ‐ YostRisk and ReturnChapter 12: Sections 12.1 ‐ 12.3Chapter 13 : Sections 13.4 ‐ 13.6[through page (black numbers) 372]The CAPM[pages (black numbers) 380‐381]Chapter 12 Update258Risk• What determines the required return on an investment?• Two things to remember about risk:– There is a reward for bearing risk.– The greater the risk, the greater the potential reward.259Quote“October. This is one of the particularly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August, and February.”‐‐ Mark Twain260Risk and ReturnFINC 3610 ‐ YostReturns• Cash flows for shares of stock:––• Example: You purchased 100 shares of stock in Obama Enterprises, Inc. last year for $50. You just received a $5 dividend. The market value of the stock is now $65. What are your dollar and percentage returns?261Returns• Example: You purchased 100 shares of stock in Yostman, Inc. last year for $30. You just received a $1 dividend. The market value of the stock is now $20. What are your dollar and percentage returns?262Returns• What about for bonds?263uemarket val Begninning uemarket valin Changeperiodover flowsCash return PercentageRisk and ReturnFINC 3610 ‐ YostA Financial History Lesson: 1926 ‐ 2007Investment Average Return Risk Premium Large Company StocksSmall Company StocksLong‐Term Corporate BondsLong‐Term Govt. BondsU.S. Treasure Bills26412.3%17.1%6.2%5.8%3.8%Risk Premium: The ex cess return required from an investment in a risky asset over that required from a risk‐free asset.Diversification and Risk• Nondiversifiable Risk: A risk that influences a _____________ of assets. Also referred to as systematic risk, market risk, or syncratic risk.• Diversifiable Risk: A risk that affects at most a _____________ of assets. Also referred to as unsystematic risk, unique risk, asset‐specific risk, or idiosyncratic risk.265Diversification and Risk• The Principle of Diversification: Spreading an investment across a number of assets will eliminate ________, but ________, of the risk.266Risk and ReturnFINC 3610 ‐ YostDiversification and Risk267pSample SizeDiversification and Risk• Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.• The expected return on an asset depends only on that asset’s systematic risk.268Systematic Risk and Beta• Beta Coefficient (): The amount of systematic risk present in a particular risky asset relative to the market portfolio (which has a beta of 1.0).269Risk and ReturnFINC 3610 ‐ YostThe Capital Asset Pricing Model (CAPM)• The CAPM: An equilibrium asset pricing model showing that the expected return for a particular asset depends on the pure time value of money plus a reward for bearing systematic risk.270fMifiRRRR CAPMThe Security Market Line271RiiAn Example• What is the expected return on a share of stock whose beta is 1.15 if the risk‐free rate is 4% and the expected return on the market is 10%?• What if the beta is 2?272Risk and ReturnFINC 3610 ‐ YostSuggested Problems• Concepts Review and Critical Thinking Questions– Chapter 13: 1, 2, and 4• Questions and Problems:– Chapter 12: 1, 2, 3, and 4 (a and b)– Chapter 13: 13, 14, 15, and