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Risk and
Return
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Risk Defined
In the context of business and finance, risk is defined
as the chance of suffering a financial loss.
Assets (real or financial) which have a greater chance of loss
are considered more risky than those with a lower chance of
loss.
Risk may be used interchangeably with the term uncertainty
to refer to the variability of returns associated with a given
asset.
Other sources of risk are listed on the following slide.
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where
rt = actual, expected, or required rate of return during period t
Ct = cash (flow) received from the asset investment in the time
period t 1 to t
Pt = price (value) of asset at time t
Pt 1 = price (value) of asset at time t 1
2012 Pearson Education
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where
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Figure 8.3
Bell-Shaped Curve
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Risk of a Portfolio
In real-world situations, the risk of any single
investment would not be viewed independently of
other assets.
New investments must be considered in light of
their impact on the risk and return of an investors
portfolio of assets.
The financial managers goal is to create an
efficient portfolio, a portfolio that maximum
return for a given level of risk.
2012 Pearson Education
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where
wj = proportion of the portfolios total
dollar value represented by asset j
rj = return on asset j
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Risk of a Portfolio
Diversification is enhanced depending upon the extent to
which the returns on assets move together.
This movement is typically measured by a statistic known as
correlation as shown in the figure below.
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Figure 8.6
Possible Correlations
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Risk of a Portfolio:
Adding Assets to a Portfolio
Portfolio
Risk (SD)
Unsystematic (diversifiable) Risk
M
Systematic (non-diversifiable) Risk
0
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
# of Stocks
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Risk of a Portfolio:
Adding Assets to a Portfolio
(cont.)
Portfolio
Risk (SD)
0
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
# of Stocks
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Figure 8.8
Beta Derivation
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Figure 8.9
Security Market Line
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Figure 8.10
Inflation Shifts SML
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Figure 8.11
Risk Aversion Shifts SML
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