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Risk and Return
Chapter 11
Key Concepts and Skills
• Know how to calculate expected returns • Understand the impact of diversification • Understand the systematic risk principle • Understand the security market line
• Understand the risk-return trade-off
Copyright ª 2007 McGrawHill Australia Pty Ltd 112
PPTs t/a Essentials of Corporate Finance by Ross,
Chapter Outline
• Expected Returns and Variances • Portfolios
• Announcements, Surprises and Expected Returns • Risk: Systematic and Unsystematic
• Diversification and Portfolio Risk • Systematic Risk and Beta
• The Security Market Line
• The SML and the Cost of Capital: A Preview
Copyright ª 2007 McGrawHill Australia Pty Ltd 113
PPTs t/a Essentials of Corporate Finance by Ross,
Expected Returns
• Expected returns are based on the probabilities of possible outcomes
• In this context, “expected” means average if the process is repeated many times
• The “expected” return does not even have to be a possible return
n E(R) piR
i 1
Copyright ª 2007 McGrawHill Australia Pty Ltd 114
PPTs t/a Essentials of Corporate Finance by Ross,
Example: Expected Returns
• Suppose you have predicted the following returns for shares C and T in three possible states of nature. What are the expected returns?
– State – Boom
– Normal
– Recession
Probability C T 0.3 0.15 0.25 0.5 0.10 0.20
0.2 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99% • RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
Copyright ª 2007 McGrawHill Australia Pty Ltd 115
PPTs t/a Essentials of Corporate Finance by Ross,
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