Wk 8: Risk and return I

  1. Percentage return
    • Percentage return: the sum of the cash received and the change in value of the asset, divided by the initial investment.
    • Dividend + ending market value - beginning market value)/ beginning market value
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  2. Average return
    • Average year return for stock.
    • Sum of return for each period/ number of periods.
    • Calc: type in each number followed by sigma, then press down shift 7
  3. Holding period returns
    • Total return on the investment
    • HPR= (1 + return1) x (1+return2).... -1
  4. What is risk?
    • How certain you are that you will receive a particular return. Higher risk means you are less certain.
    • Risk can be defined as the uncertainty of the future outcomes of the probability of an adverse outcome.
    • Alternatively, it is a chance of financial loss or the variability of returns associated with an asset.
    • A common measure of risk is the variance or SD of expected returns.
  5. Use of standard deviation and variance in assessing risk: advantages
    • Underlying intuition is that the greater the difference between actual payoff and expected value, the greater the risk.
    • By squaring the difference and multiplying each difference by its associated probability then summing, this yields the variance of the possible outcome.
    • Variance takes into account the number of potential outcomes or the probability of each outcome. 
    • It also provides a measure of risk that has a consistent interpretation across different situations or assets.
    • Square root of variance gives standard deviation.
  6. Interpreting the variance and standard deviation
    • Var and SD especially useful measures of risk for variables that are normally distributed.  
    • Returns for many assets in finance tend to be approximately normally distributed.
    • Standard deviation provides a convenient way of calculating the probability that the return on an asset will fall within a particular range. 
    • The expected return on an asset equals the mean of the distribution and the SD is a measure of the uncertainty associated with the return.
  7. Standard deviation and variance calc
    • Standard deviation= square root of variance
    • Standard deviation calc: find the average returns (returns, sigma, down shift 7) then press shift down 8
    • To find Variance: square SD
  8. Normal distribution
    • Normal distribution: a symmetric frequency distribution that is completely described by its mean and SD. AKA bell curve.1 SD= 68.26% of population
    • 1.645 SD= 90%
    • 1.96 SD= 95%
  9. Risk measurement: coefficient variation

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    • If two investments with opposite return and risk, which would you choose?
    • Coefficient variation: SD/E(r)
    • is a ratio between SD and the return. 
    • Tells you for every 1% return, how much risk do you take?
    • eg. 0.06/0.08= 0.75
    • 0.08/0.10= 0.8
    • Choose the one with lowest number.
  10. Difference risk attidues
    • Risk neutral: a risk neutral investor is one who neither likes no dislikes risk. Whose utility is unaffected by risk. 
    • Such investors focus on expected return. 
    • Risk averse investor: one who demands compensation in the form of higher expected returns in order to be induced into taking more risk. 
    • Risk seeking investor: one who derives utility from being exposed to risk. May be willing to give up some expected return in order to be exposed to additional risk.
  11. The risk-return trade off
    • Standard assumption in finance theory is that investors are 'risk averse'.
    • Such investors regard risk ( or uncertainty) as undesirable and therefore require compensation for assuming risk in the form of an enhanced expected return. 
    • For such investors, there is a trade off between risk and expected return. 
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  12. Risk premium
    • The risk premium is the added return (over the risk free rate) resulting from bearing risk. 
    • Also called excess return. 
    • Eg. if current rate for one year treasury bill is 2%, what is the excess return on Apple's stock if it earns an average of 12.9%?
    • =10.9%
  13. Types of risk
    • Firm specific: unsystematic risk. Affects only a specific company.
    • It does not affect other firms
    • Market risk: systematic risk. Affects the economy as a whole and therefore affects all shares.
  14. Diversification
    • Diversification: by investing intwo or more assets whose values do not always move in the same direction at the same time, investors can reduce the risk of the portfolio. 
    • The risk is diversified away in a portfolio is firm specific. 
    • Market risk is not diversifiable.
  15. What is the risk premium for unsystematic/systematic risk?
    • Unsystematic: zero. Should not be compensated for firm specific risk as can diversify.
    • Systematic: positive because cannot diversify, affects everyone
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kirstenp
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Wk 8: Risk and return I
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Wk 8: Risk and return I
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