FI 302 Chapter 8 Risk and Rates of Return Expected Return SML rRF Risk What is investment risk Chance to win big or lose big Two types Stand alone risk Portfolio risk Investment risk is related to the probability of earning low or negative actual return Greater the chance of lower than expected negative returns the riskier the investment Probability Distributions Lists all possible outcomes and the probability of each occurrence Can be seen graphically looks like steep wide versions of normal curve When distributions are wide there is high risk Less risk with tight distributions Hypothetical Investment Alternatives T Bill the return doesn t change they will return the promised regardless of the economy High tech moves with the economy and has a positive correlation typical Collections countercyclical with economy and negative correlation unusual Example cigarette alcohol Vice companies Relationship since high tech and collections move with the market your portfolio could bene t from having securities in each of these Calculating Expected Return return Expected rate of r N r rP ii r 1i 1 0 12 4 27 0 2 30 0 2 7 0 4 15 0 1 45 Calculating Standard Deviation Standard deviation 3 Variance 2 r P r 2 i N 1i Total Risk Diversi able Risk Un diversi able Risk Diversi able Risk unique risk that can be eliminated Un diversi able risk market risk systematic risk inherent in the market cannot be eliminated Investor Attitude Toward Risk Risk aversion Investors avoid risk unless compensated Risk premium the difference between a return on a risky asset and a rissoles asset which serves as a compensation for investors to hold riskier securities Investors will take on risk in exchange for compensation Portfolio Construction Risk and Returns Assume two stock portfolio is created w 50 000 invested in High Tech and also in Collections Portfolio s expected return is the weighted average of the returns of the portfolio s component assets Std Deviation requires that a new probability distribution for returns be constructed Return is based on the weight of what you invest in Notes About Std Deviation Your average stock has a standard deviation of about 35 Your average portfolio has a standard deviation of about 20 Diversi cation comes from securities being negatively correlated with one another moving in opposite directions so risk is reduced and diversi cation gives bene ts Correlation Coef cient ranges from 1 x 1 Standardized relative measure of association between a pair of securities Can range anywhere between 1 x 1 Perfect Positive Correlation Negative Correlation