Risk and Return Fundamentals Explained

Introduction to Risk and Return Valuing risky assets - a task fundamental to financial management The three-step procedure is called discounted cash flow (DCF) analysis. ,[object Object],1. Determine the asset’s expected cash flows 2. Choose discount rate that reflects asset’s risk 3. Calculate present value (PV cash inflows - PV outflows)

Historical vs. Expected Returns Decisions Must Be Based On Expected Returns There Are Many Ways to Estimate Expected Returns Assume That Expected Return Going Forward Equals the Average Return in the Past ,[object Object]

Risk and Return Fundamentals Equity risk premium: the difference in equity returns and returns on safe investments ,[object Object],[object Object]

Risk Aversion Risk Neutral ,[object Object],Risk Seeking ,[object Object], Risk Averse ,[object Object],Historical Returns on Financial Assets Are Consistent with a Population of Risk-Averse Investors

Probability Distribution ,[object Object],[object Object]

Two Assets With Same Expected Return But Different Distributions

Return on an Asset Return - The Total Gain or Loss Experienced on an Investment Over a Given Period of Time. An example.... Investor Bought Utilyco for $60/share Dividend = $6/share Sold for $66/share

Arithmetic Versus Geometric Returns ,[object Object],[object Object],[object Object],[object Object],The Difference Between Arithmetic Returns and Geometric Returns Gets Bigger the More Volatile the Returns Are

Arithmetic Versus Geometric Returns The Difference Between Arithmetic Returns and Geometric Returns Gets Bigger the More Volatile the Returns Are AAR = 6.25% GAR = 5.78% ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Distribution of Historical Stock Returns, 1900 - 2003 Percent return in a given year Probability distribution for future stock returns is unknown. We can approximate the unknown distribution by assuming a normal distribution. <-30 -30 to -20 to -10 to 0 to 10 to 20 to 30 to 40 to >50 -20 -10 0 10 20 30 40 50

Variance ,[object Object],[object Object],[object Object]

Expected Return For A Portfolio ,[object Object],[object Object]

Two-Asset Portfolio Standard Deviation Correlation Between Stocks Influences Portfolio Volatility

Correlation Coefficients And Risk Reduction For Two-Asset Portfolios 10% 15% 20% 25% 0% 5% 10% 15% 20% 25% Standard Deviation of Portfolio Returns Expected Return on the Portfolio  is +1.0 -1.0 <  <1.0  is -1.0

Portfolios of More Than Two Assets ,[object Object],Expected Return of Portfolio Is Still The Average Of Expected Returns Of The Two Stocks How Is The Variance of Portfolio Influenced By Number Of Assets in Portfolio?

Variance – Covariance Matrix 5 4 3 2 1 5 4 3 2 1 Asset The Covariance Terms Determine To A Large Extent The Variance Of The Portfolio 5 4 3 2 1 5 4 3 2 1 Asset 5 4 3 2 1 5 4 3 2 1 Asset Variance of Individual Assets Account Only for 1/25 th of the Portfolio Variance

Effect of Diversification on Portfolio Variance

Portfolio Risk ,[object Object],[object Object],[object Object],[object Object],[object Object]

What Is a Stock’s Beta? Beta Is a Measure of Systematic Risk What If Beta > 1 or Beta <1? ,[object Object],[object Object],What If Beta = 1? ,[object Object],[object Object]

Diversifiable And Non-Diversifiable Risk ,[object Object],[object Object],[object Object],[object Object]

How Risky Is an Individual Asset? First Approach – Asset’s Variance or Standard Deviation ,[object Object],[object Object]

The Impact Of Additional Assets On The Risk Of A Portfolio Number of Securities (Assets) in Portfolio Portfolio Risk,  k p Nondiversifiable Risk Diversifiable Risk Total risk 1 5 10 15 20 25

Risk and Return Fundamentals Explained

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Risk and Return Fundamentals Explained