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1

Introduction to Risk and Return

Real Return
Expected Inflation Rate
Return
%
RF

Risk

2

3

Return =

(Amount received – Amount invested) Amount invested

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5

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Illustrated

Probability
Outcomes that produce harm
The range of total possible returns
on the stock A runs from -30% to
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
represent risk to the investor.
A
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock

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12

n
_
2
= 1
Ex post
( r − r
n − 1
)
i
σ
i
=

_

i

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2
Variance =
σ

n
i
=
1

n

i

=

1

^

2

P
i

IBM

2

2

2

1
2

IBM T - bills

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Shell

USR

M

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22

KP =
5
=
12%

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n
(k
i
i
=
1

2
2
2
2
2
(12%- 12%)
+
(12%- 12%)
+
(12%- 12%)
+
(12%- 12%)
+
(12%- 12%) /(5
1)

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2
2
2
2
σ
=
σ w σ w
+
+ 2
w w ρ σ σ
p
A
A
B
B
A
B
A B
,
A
B

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COV
ρ
AB
=
AB
σ σ
A
B

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COV = ρ σ σ
AB
AB
A
B

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25
15
0
-10
25
15
0
-10

30

25
25
15
15
0
0
-10
-10

25
15
0
-10

31

Illustrating diversification effects of a stock portfolio

σ p (%)
Company-Specific Risk
35
Stand-Alone Risk, σ p
20
Market Risk
0
10
20
30
40
2,000+

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