Risk & Return Flashcards
What is the expected return?
Historical or holding period or realized rate of return
Holding period = Price End of period + Dividend - Price Beginning of period
What is the holding period rate of return?
Dollar gain (Price End + Div. - Price Beginning) / Price beginning of Period
What are cash flows?
The expected benefits or returns, an investment generates come in the form of cash flows
Cash flows are used to measure returns
What is the expected cash flow?
Is the weighted average of the possible cash flows outcomes such that the weights are the probabilities of the occurence of the various state of the economy
Expected Cash flow (x) = Sum(Pbi * CF)
Pb = probabilities of outcome i CFi = cash flows in outcome i
What isthe expected rate of return?
% expected return on 1000$ investment. Weighted average of all the possible returns, weighted by the probability that each return will occur.
Expected return (%)= Sum(PBi*ri)
Pb = probabilities of outcome i r = expected % return in outcome i
What are the three important questions concerning risk?
- What is risk?
- How do we measure risk?
- Will diversification reduce the risk of portfolie?
How can we define risk?
Risk refers to potential variability in future cash flows
The wider the range of possible future events that can occur, the greater the risk
Thus the return on common stock is more risky than returns from investing in savings account in a bank
How do we measure risk?
compare the expected return
Standard deviation is one way to measure risk. It measures the volatility of portfolio returns
(Square root of the weighted average )
What is a portfolio?
Combining several assets
Which kind of risks exist?
two types of risk:
systematic risk (market risk): affects all firms e.g. war, tax change
unsystematic risk (company unique risk): CEO change etc.
Only non systematic risk can be reduced or eliminated through effective diversifiaction
What means the correlation in portfolio management?
To reduce the risk
Two stocks are perfectly positively correlated -> diversification has no effect on risk
Two stocks are perfectly negatively correlated -> portfolio is perfectly diversified
What should we consider while building our portfolio?
Pick assets that have negative or low correlation to attain diversification benefits
What is the monthly holding return?
(Price end of month - price beginning of month) / price beginning of month
How do we interprete beta?
Beta is the risk that remains for a company even after we have diversified our portfolio
Beta = 0 -> Stock has no systematic risk
Beta = 1 -> Systematic risk is equal to typical risk
Beta > 1 -> Systematic risk greater than typical stock
beta is usually between 0.6 and 1.6
What is the Portfolio Beta?
indicates the percentage change on average of the portfolio for every 1% change in the general market
ß portfolio = Sum(wj * ßj)
wj = % invested in stock j ?j = beta of stock j
What are other advantages of diversification?
The market rewards diversification
Through effective diversification, we can lower risk without sacrificing expected returns and we can increase expected returns without having to assume more
What is Asset Allocation?
Diversifying among different kinds of asset types (treasury bills, bonds, stocks..)
Asset allocation decision has to be made today, payoff in the future will depend on the mix chosen before.
“Most important decision” while managing an investment portfolio
Reducing risk usually also reduces return.
Holding period also matters!
What is the Inverstor’s Required Rate of Return?
is the minimum rate of return necessary to attract an investor to purchase or hold a security.
RRoR = risk free rate of return + risk premium
What is the risk free rate?
The required rate of return or discount rate for risk-less investments.
Usually measured by U.S. treasurybill rate
What is the risk premium?
Additional return we must expect to receive for assuming risk
When risk increases, we will demand additional expected returns
What is the Capital Asset Pricing Model?
Equates the expected rate of return on a stock to the risk free rate plus a risk premium for the systematic risk.
Intuitive approach for thinking about the return that an investor should require on an investment.
What is the CAPM Formula?
Required return = Risk free rate of return (rf) + beta * (required return on portfolio(rm) - risk free rate of return)
Example:
Market risk = 12%
Risk-free rate = 5%
Required return = 5% + Beta * (12% - 5%)
If Beta = 0 Required return = 5%
If Beta = 1 Required return = 12%
If Beta = 2 Required return = 19%
What is the Security Market Line? (SML)
Is a graphic representation of the CAPM,where the line shows the appropiate required rate of return for a givens stocks systematic risk
