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Lecture 5: Risk and Rate of Return - Coggle Diagram
Lecture 5: Risk and Rate of Return
Investors' Attitude towards Risk
Risk averse, require higher rates of return to encourage them to hold riskier securities
Risk premium: The difference between the return on a risky asset and a riskless asset.
Calculating Rate of Return on an Investment
Return = (Ending value - Amount invested) / Amount invested
Investment Risk
Probability of earning a return that is different from expected. The greater the chance of earning a different return, the riskier the investment.
Stand-alone risk
Diversifiable risk
Market risk
Portfolio risk
Calculating Expected Return
Measuring Standard Deviation for each investment
Coefficient of Variation (CV)
A standardised measure of dispersion about the expected value that shows the risk per unit of return. Useful when comparing investments with different expected returns.
CV = Standard Deviation / Expected Return
p = -1.0 (Portfolio is riskless. Stocks move counter-cyclically)
p = 1.0 (Stocks move together)
Comments about diversification
Most stocks are positively, though not perfectly, correlated with the market, i.e.p between 0 and 1.
Combining stocks in a portfolio generally lowers risk
Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large stock portfolios, tends to converge to 20%
CAPM
Model linking risk and required returns. Suggests that a stock's required return equals the risk-free return plus a risk premium that reflects the stock's risk after diversification.
Market Risk Premium
Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.
Size depends on perceived risk of stock market and investors' degree of risk aversion
Beta
Measures a stock's market risk and shows a stock's volatility relative to the market
Expected change in its return given a 1% change in the return of the market portfolio.
beta = 1.0, security is as risky as average stocks.
beta > 1.0, security is riskier than average.
beta < 1.0, security is less risky than average
Security Market Line (SML)
Increase/Decrease in inflation --> intercept changes, no change in slope
Increase/Decrease in MRP --> Intercept remains the same, slope changes.
Types of Returns
Required returns (need)
Expected returns (want)
Realised returns (actual)
