CHAPTER 8Risk and Rates of Return.ppt

CHAPTER 8Risk and Rates of Return This chapter is most important and will be emphasized in tests. Chapter Objectives Define and measure the expected rate of return of an individual investment Define and measure the riskiness of an individual investment Compare the historical relationship between risk and rates of return in the capital markets Explain how diversifying investments affect the riskiness and expected rate of return of a portfolio or combination of assets Explain the relationship between an investor’s required rate of return and the riskiness of the investment Investment returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return = ________________________ Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%. What is investment risk? Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. The greater the range of possible events that can occur, the greater the risk The Chinese definition Two types of investment risk Stand-alone risk (when the return is analyzed in isolation.) Portfolio risk (when the return is analyzed in a portfolio.) PART I: Standard alone risk The risk an investor would face if s/he held only one asset. Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Which firm is more likely to have a return closer to its expected value? Firm X? Firm Y? Investor attitude towards risk Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Who wants to be a millionaire? Risk premium – the difference between the return on a risky asset and les