Learning Goals
LG1 Understand the meaning and fundamentals of risk, return, and risk preferences. LG2 Describe procedures for assessing and measuring the risk of a single asset. LG3 Discuss the measurement of return and standard deviation for a portfolio and the concept of correlation.
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Focus on Ethics
If It Sounds Too Good To Be True...
For many years, investors around the world clamored to invest with Bernard Madoff.
Madoff generated high returns year after year, seemingly with very little risk. On December 11, 2008, the U.S. Securities and Exchange Commission (SEC) charged Madoff with securities fraud. Madoffs hedge fund, Ascot Partners, turned out to be a giant Ponzi scheme. What are some hazards of allowing investors to pursue claims based their most recent accounts statements?
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where
rt = actual, expected, or required rate of return during period t Ct = cash (flow) received from the asset investment in the time period t 1 to t Pt = price (value) of asset at time t Pt = price (value) of asset at time t 1
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2012 Pearson Prentice Hall. All rights reserved.
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Risk-neutral is the attitude toward risk in which investors choose the investment with the higher return regardless of its risk.
Risk-seeking is the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.
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Range is a measure of an assets risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.
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Matter of Fact
Beware of the Black Swan
Is it ever possible to know for sure that a particular outcome can never happen, that the chance of it occurring is 0%?
In the 2007 best seller, The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb argues that seemingly improbable or even impossible events are more likely to occur than most people believe, especially in the area of finance. The books title refers to the fact that for many years, people believed that all swans were white until a black variety was discovered in Australia.
Taleb reportedly earned a large fortune during the 20072008 financial crisis by betting that financial markets would plummet.
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where
rj = return for the jth outcome Prt = probability of occurrence of the jth outcome n = number of outcomes considered
2012 Pearson Prentice Hall. All rights reserved.
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In general, the higher the standard deviation, the greater the risk.
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Table 8.4a The Calculation of the Standard Deviation of the Returns for Assets A and B
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Table 8.4b The Calculation of the Standard Deviation of the Returns for Assets A and B
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Table 8.5 Historical Returns and Standard Deviations on Selected Investments (19002009)
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Matter of Fact
All Stocks Are Not Created Equal
Stocks are riskier than bonds, but are some stocks riskier than others?
A recent study examined the historical returns of large stocks and small stocks and found that the average annual return on large stocks from 1926-2009 was 11.8%, while small stocks earned 16.7% per year on average. The higher returns on small stocks came with a cost, however.
The standard deviation of small stock returns was a whopping 32.8%, whereas the standard deviation on large stocks was just 20.5%.
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A higher coefficient of variation means that an investment has more volatility relative to its expected return.
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Risk of a Portfolio
In real-world situations, the risk of any single investment would not be viewed independently of other assets. New investments must be considered in light of their impact on the risk and return of an investors portfolio of assets. The financial managers goal is to create an efficient portfolio, a portfolio that maximum return for a given level of risk.
2012 Pearson Prentice Hall. All rights reserved.
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where wj = proportion of the portfolios total dollar value represented by asset j rj = return on asset j
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Table 8.6a Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY
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Table 8.6b Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY
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The correlation coefficient is a measure of the degree of correlation between two series.
Perfectly positively correlated describes two positively correlated series that have a correlation coefficient of +1.
Perfectly negatively correlated describes two negatively correlated series that have a correlation coefficient of 1.
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Table 8.7 Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ
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Risk of a Portfolio: Correlation, Diversification, Risk, and Return Consider two assetsLo and Hiwith the characteristics described in the table below:
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Global Focus
An International Flavor to Risk Reduction
Elroy Dimson, Paul Marsh, and Mike Staunton calculated the historical returns on a portfolio that included U.S. stocks as well as stocks from 18 other countries.
This diversified portfolio produced returns that were not quite as high as the U.S. average, just 8.6% per year. However, the globally diversified portfolio was also less volatile, with an annual standard deviation of 17.8%.
Dividing the standard deviation by the annual return produces a coefficient of variation for the globally diversified portfolio of 2.07, slightly lower than the 2.10 coefficient of variation reported for U.S. stocks in Table 8.5.
2012 Pearson Prentice Hall. All rights reserved.
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Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk.
2012 Pearson Prentice Hall. All rights reserved.
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The market return is the return on the market portfolio of all traded securities.
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where
rt = required return on asset j RF = risk-free rate of return, commonly measured by the return on a U.S. Treasury bill bj = beta coefficient or index of nondiversifiable risk for asset j rm = market return; return on the market portfolio of assets
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Group Exercises
Critical Thinking Problems
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