OSU BA 340 - Chapter 5 Risk and Return

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Chapter 5 Risk and ReturnReturnsHolding Period ReturnsHistorical ReturnsRisk Using Variance or Standard DeviationsRisk as UncertaintyReturns in an Uncertain WorldSlide 8Risk and Return TradeoffProblemsChapter 5Chapter 5Risk and ReturnRisk and ReturnReturnsReturnsDollar and PercentageDollar and PercentageHolding Period ReturnsHolding Period ReturnsConverting to Annual ReturnsConverting to Annual ReturnsHistorical ReturnsHistorical ReturnsRisk using Variance or Standard DeviationRisk using Variance or Standard DeviationRisk as UncertaintyRisk as UncertaintyReturns in an Uncertain WorldReturns in an Uncertain WorldRisk and Return TradeoffRisk and Return TradeoffReturnsReturnsCalculating a returnCalculating a returnDollar ReturnDollar ReturnEnding Value + Distributions – Original CostEnding Value + Distributions – Original CostExample 5.1, Bought Trading Card for $5.00 and Example 5.1, Bought Trading Card for $5.00 and sold it for $6.25, Dollar Return (Profit) $1.25sold it for $6.25, Dollar Return (Profit) $1.25Percentage ReturnPercentage Return[(Ending Value + Distributions) / Original Cost] – 1[(Ending Value + Distributions) / Original Cost] – 1Example 5.1, $1.25 / $5.00 = 25%Example 5.1, $1.25 / $5.00 = 25%Calculating a return with distributionsCalculating a return with distributionsExample 5.2, Stock with dividendExample 5.2, Stock with dividendHolding Period ReturnsHolding Period ReturnsHolding Period Returns (HRP)Holding Period Returns (HRP)The return for the length of time that investment is The return for the length of time that investment is heldheldNot consistent with interest rates from Chapter 4Not consistent with interest rates from Chapter 4Need to convert to annual basis for comparisonNeed to convert to annual basis for comparisonAnnualized return = (1 + HRP)Annualized return = (1 + HRP)nn – 1 – 1Warning on extrapolation of holding period Warning on extrapolation of holding period returns for less than a yearreturns for less than a yearCompounding requires each additional investment Compounding requires each additional investment period with same holding period returnperiod with same holding period returnHistorical ReturnsHistorical ReturnsYear by Year ReturnsYear by Year ReturnsFour different investmentsFour different investments3-Month Treasury3-Month TreasuryLong-Term Government BondsLong-Term Government BondsLarge Company StocksLarge Company StocksSmall Company StocksSmall Company StocksLarge Swings from year to yearLarge Swings from year to yearMost consistent performer, 3-Month TreasuryMost consistent performer, 3-Month TreasuryRelationship of average return and standard Relationship of average return and standard deviation – first look at risk and return tradeoffdeviation – first look at risk and return tradeoffRisk Using Variance orRisk Using Variance orStandard DeviationsStandard DeviationsMeasure of the swing from year to year: Measure of the swing from year to year: Variance or Standard DeviationVariance or Standard DeviationGreater the variance or standard deviation the Greater the variance or standard deviation the greater the potential outcomesgreater the potential outcomesStandard Deviation (Standard Deviation (σσ) = Variance) = Variance1/21/2 ( (σσ22))Normal Distribution helps explain probability of Normal Distribution helps explain probability of a potential outcomea potential outcome   12naveragexxVaria nc eiRisk as UncertaintyRisk as UncertaintyRisk is the uncertainty in the outcome of an Risk is the uncertainty in the outcome of an eventeventAn event where the outcome is known before An event where the outcome is known before the event is free of uncertainty or risk-freethe event is free of uncertainty or risk-freeExample of a horse raceExample of a horse raceBefore the race, all horses entered in the race have a Before the race, all horses entered in the race have a chance to winchance to winHowever, some have a better chance to win than However, some have a better chance to win than othersothersStandard Deviation will be one measure of riskStandard Deviation will be one measure of riskReturns in an Uncertain WorldReturns in an Uncertain WorldInvestments or bets are made prior to the Investments or bets are made prior to the eventeventNeed to calculate the expected outcome Need to calculate the expected outcome of the eventof the eventNeed the list of all potential outcomesNeed the list of all potential outcomesNeed the chance of each potential outcomeNeed the chance of each potential outcomeExpected Return = Expected Return = ΣΣ outcome outcomeii x probability x probabilityiiPayoff or return for investment is the outcomePayoff or return for investment is the outcomeReturns in an Uncertain WorldReturns in an Uncertain WorldVariance or Standard Deviation in Uncertain Variance or Standard Deviation in Uncertain WorldWorldNeed the probabilities of all outcomesNeed the probabilities of all outcomesNeed the expected outcomeNeed the expected outcomeΣΣ(outcome(outcomeii – expected outcome) x probability – expected outcome) x probabilityiiExample 5.3 – Expected Return of Long BondExample 5.3 – Expected Return of Long BondFour potential outcome (states of the world)Four potential outcome (states of the world)Probability of each outcome known (or estimated)Probability of each outcome known (or estimated)Calculate expected return of 6.35%Calculate expected return of 6.35%Calculate variance of 0.7275% or standard deviation Calculate variance of 0.7275% or standard deviation of 0.8529%of 0.8529%Risk and Return TradeoffRisk and Return TradeoffObjective: Maximize Return and Minimize RiskObjective: Maximize Return and Minimize RiskMust tradeoff increases risk and return with Must tradeoff increases risk and return with decreasing risk and returndecreasing risk and returnInvestment Rule #1 – Two assets with same expected Investment Rule #1 – Two assets with same expected return, pick one with lower riskreturn, pick one with lower riskInvestment Rule #2 – Two assets with the same risk, Investment Rule #2 – Two assets with the same risk, pick one with higher returnpick one with higher returnWhat to do when one investment has both What to do when one investment has both higher return and more risk versus


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OSU BA 340 - Chapter 5 Risk and Return

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