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CHAPTER 5: RISK AND RETURN, CHRISTINE ISABELLE AJJULUS 2020979117 BA242…
CHAPTER 5: RISK AND RETURN
RISK
TYPES OF RISK
UNSYSTEMATIC RISK
(Controllable risk)
FINANCIAL RISK
-Associated with the way a company finances its companies
-based on its capital structure
LIQUIDITY RISK
-Arises when an asset cant be liquidated easily in the 2nd market
BUSINESS RISK
Internal Business Risk
-Associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it.
External Business Risk
-Operating condition imposed upon the firm by circumstances beyond its control
SYSTEMATIC RISK
(Uncontrollable risk)
INTEREST RATE RISK
-Refers to uncertainty of future market values and the size of future income
-caused by fluctuations of IR level
PURCHASING POWER RISK
-Refer to the impact of inflation or deflation on an investment
-:arrow_up: price on g&s
-:arrow_down: price on g&s
MARKET RISK
-Refers to variability of returns due to fluctuations in the stock market
-caused by investor reaction to in/tangible events
ASSIGNING RISK ALLOWANCES
-One way of quantifying risk and building a required rate return would be to express the required rate as comprising of riskless rate plus compensation for individual risk factors
R=I+P+B+F+M+O
SECURITY ANALYSIS
-Cant be predicted with certainly
-ex: stock price will :arrow_up: / :arrow_down: by exactly how much
Measures of Expectation using variances
-uncertainty represents unsatisfactory condition of a firm
-Two measures associate with probabilities or distributions of possible outcomes
:central tendency
:dispersion
Expectation of returns measurement can be stated as expected Rate of Return / Ringgit
Terms Related to Risk Measurement
Mean/expected value or rate of return (R)
Median(ME) is value of outcomes divide the prob. distribution
Mode(MO) is outcome of which probability of occurrence is the greatest
Variance(V) is weighted average of squared deviations
Standard deviation(SD) is square root of variance
Coefficient Variance(CV) is standard measures or risk per unit of return
R = ∑PO
Variance = ∑P (O – R)2
Std. Dev = √Variance
Measuring Systematic Risk, Beta(β)
A statistical measure of risk which the amount of systematic risk present in a particular risky asset
Capital asset pricing model (CAPM) links risk β to the level of required return
TOTAL RISK= DIVERSIFIED RISK + DIVERSIFIABLE RISK
β (non-diversiifiable risk)
β can be +ve / -ve
RETURN
CAPITAL GAIN
-gain investor makes selling asset
DIVIDEND YIELD
-reward investor gets by owning asset
HOLDING PERIOD RETURN(HOR)
Total return= DY + CG
Total % Return= D + CG / Initial inv
Total & Return= D1 + (P1 - P0) / P0
EFFICIENT PORTFOLIO
-A portfolio is efficient when it is expected to yield the highest return/smallest portfolio risk for the level of risk accepted/specified level of expected return
EVALUATING RISK
-in the end, investors must relate the risk perceived in a given security not only to return but also their own attitudes towards risk
-Investor should select the opportunities that offer the highest returns
CAPITAL ASSET PRICING MODEL (CAPM)
Uses β to link between risk and return
can be viewed both as a mathematical equation and graphically, as the SECURITY MARKET LINE(SML)
Rs= Rf + βs(Rm-Rf)
ASSUMPTIONS OF CAPM
Investors are risk averse. They take decision based on risk and return assessment
The purchase/sale of a security can be undertaken in infinitely divisible units
No transaction costs, taxes
Investor can borrow & lend freely at a riskless rate of interest
SECURITY LINE MARKET(SML)
-When CAPM is depicted graphically, called SML
-SML tells us the required return an investor should earn in the marketplace for any level of systematic β risk.
-can be plotted using the equation
CAPITAL MARKET LINE
-CML derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return
RELATIONSHIP BETWEEN RISK AND RETURN
The line that reflects combination of risk and return available on alternative inv referred to SML
SML reflects the risk-return combinations for all risky assets in capital market
Risk-Return Trade-Off
Low Risk, Low Potential Return
High Risk, High-Potential Return
CHRISTINE ISABELLE AJJULUS
2020979117
BA242 FIN430 2A2
CHAP 5:RISK AND RETURN MINDMAP