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CHAPTER 5
Risk and Rates of Return
Standalone risk Portfolio risk
Risk & return: CAPM / SML
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Investment returns
The rate of return on an investment can be calculated as follows:
(Amount received – Amount invested)
Return = ________________________ Amount invested
For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is:
($1,100 $1,000) / $1,000 = 10%.
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What is investment risk?
Two types of investment risk Standalone risk
Portfolio risk
Investment risk is related to the probability of earning a low or negative actual return.
The greater the chance of lower than expected or negative returns, the riskier the investment.
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Probability distributions
A listing of all possible outcomes, and the probability of each occurrence.
Can be shown graphically.
Firm X
Firm Y
-70 0 15 100
Rate of Return (%)
Expected Rate of Return 54
Selected Realized Returns, 1926 – 2001
Average Return
Smallcompany stocks 17.3%
Standard Deviation
33.2%
Largecompany stocks 12.7 20.2 LT corporate bonds 6.1 8.6 LT government bonds 5.7 9.4 U.S. Treasury bills 3.9 3.2
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.
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