5,Risk and Return.ppt

Risk and Return Learning Goals Understand the meaning and fundamentals of risk, return, and risk aversion. Describe procedures for assessing and measuring the risk of a single asset. Discuss the measurement of return and standard deviation for a portfolio and the concept of correlation. Understand the risk and return characteristics of a portfolio in terms of correlation and diversification, and the impact of international assets on a portfolio. Learning Goals (cont.) Review the two types of risk and the derivation and role of beta in measuring the relevant risk of both a security and a portfolio. Explain the capital asset pricing model (CAPM) and its relationship to the security market line (SML), and the major forces causing shifts in the SML. Risk and Return Fundamentals If everyone knew ahead of time how much a stock would sell for some time in the future, investing would be simple endeavor. Unfortunately, it is difficult—if not impossible—to make such predictions with any degree of certainty. As a result, investors often use history as a basis for predicting the future. We will begin this chapter by evaluating the risk and return characteristics of individual assets, and end by looking at portfolios of assets. Risk Defined In the context of business and finance, risk is defined as the chance of suffering a financial loss. Assets (real or financial) which have a greater chance of loss are considered more risky than those with a lower chance of loss. Risk may be used interchangeably with the term uncertainty to refer to the variability of returns associated with a given asset. Other sources of risk are listed on the following slide. Return Defined Return represents the total gain or loss on an investment. The most basic way to calculate return is as follows: Return Defined (cont.) Historical Returns Risk Preferences Risk of a Single Asset Risk of a Single Asset (cont.) Risk of a Single Asset: Discrete Probability Distributions Risk of a Single Asset: Continu