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Risk and return - Introduction to portfolio theory, D1 = dividend per…
Risk and return - Introduction to portfolio theory
Risk and return (an individual asset)
Valuation of a risky asset
Asset is expected to generate future cash flows
Risky asset refers to assets which have a significant degree of price volatility such as equities, high-yield bonds and commondities
Relationship between risk and return
Useful information for investors
Can determine appropiate
Useful for financial intermediaries (that lend, invest, borrow on behalf of their clients
What is return?
Total gain or loss experienced on an investment over a given period of time
Investors gain their returns from shares in the form of dividends and capital gains/losses
Formula for calculating annual return of a share is:
Annual return = D1 + (P1 + P0) / P0
What is risk?
The possibility that actual future returns will deviate from expected returns (i.e. risk represents the variability of returns)
How to measure risk?
Can be measured by the variance or standard deviation of possible returns around expected return:
greater the dispersion, greater the risk, greater variance or standard deviation
if no dispersion of possible returns, then the expected return is a certain return, there is no risk and both variance and standard deviation give a measure of zero
Risk free asset:
For example, government bonds held to maturity
Risky asset:
For example, a share investment which offers return in form of a dividend, and capital gain
Risk preferences of investors
Risk-neutral
e.g. investors who are indifferent to risk
Risk-adverse
e.g. investors who are adverse to risk
Risk-loving
e.g. investors who enjoy a gamble
Risk and return approaches of an individual asset:
Historical approach
Based on historical data (e.g historical stock returns)
Formulas:
Mean or average return
Variance of returns
Standard deviation
Probabilistic approach
Based on concept of probability distributions
Shows the possible unique outcomes and their associated probabilties
The measure of central tendency of returns is the arithmetic mean return (expected return)
Formula
The measure of dispersion, is the variance (square root - standard deviation)
Concept of covariance and correlation
D1 = dividend per share
P1 = share price per share
P0 = share price at the start of the year