Chap013_cc Return, Risk, and the Security Market Line.pptx

Chapter 13Return, Risk, and the Security Market LineCopyright ? 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinKey Concepts and Skills13-Know how to calculate expected returnsUnderstand the impact of diversificationUnderstand the systematic risk principleUnderstand the security market lineUnderstand the risk-return trade-offBe able to use the Capital Asset Pricing ModelChapter Outline13-Expected Returns and VariancesPortfoliosAnnouncements, Surprises, and Expected ReturnsRisk: Systematic and UnsystematicDiversification and Portfolio RiskSystematic Risk and BetaThe Security Market LineThe SML and the Cost of Capital: A PreviewExpected ReturnsExpected returns are based on the probabilities of possible outcomesIn this context, “expected” means average if the process is repeated many times13-Example: Expected ReturnsSuppose you have predicted the following returns for stocks C and T in three possible states of the economy. What are the expected returns? State Probability C T Boom 0.3 15 25 Normal 0.5 10 20 Recession 0.2 2 1If the risk-free rate is 4.15%, what is the risk premium? Risk premium is the difference between the expected return on a risky investment and the certain return on a risk-free investment 13-Example: Expected ReturnsWhat are the expected returns?RC = .3(15) + .5(10) + .2(2) = 9.9%RT = .3(25) + .5(20) + .2(1) = 17.7%If the risk-free rate is 4.15%, what is the risk premium? Stock C: 9.9 – 4.15 = 5.75%Stock T: 17.7 – 4.15 = 13.55%13-Variance and Standard Deviation13-Variance and standard deviation measure the volatility of returnsUsing unequal probabilities for the entire range of possibilitiesWeighted average of squared deviationsExample: Variance and Standard DeviationConsider the previous example. What are the variance and standard deviation for each stock?Stock C?2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29? = 4.50%Stock T?2 = .3(25-17.7)2 + .5(20-17.7)2