Risk And Returns
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The document discusses risk and rates of return. It states that the risk-free rate of return is used as the required rate of return for Treasury securities. For corporate stocks and bonds, the required rate of return is the risk-free rate plus a risk premium. Expected return is calculated as a weighted average of possible returns based on their probabilities. Risk is measured by a stock's standard deviation, which captures the uncertainty in possible outcomes, with higher standard deviation indicating greater risk.
Risk And Returns
- 1. Risk and Rates of Return Return Risk
- 2. Since Treasury’s are essentially free of default risk, the rate of return on a Treasury security is considered the “risk-free” rate of return. For a Treasury security, what is the required rate of return? Required rate of return = Risk-free rate of return
- 3. How large of a risk premium should we require to buy a corporate security? Required rate of return = Risk-free rate of return + Risk Premium For a corporate stock or bond , what is the required rate of return?
- 4. Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc. Required Return - the return that an investor requires on an asset given its risk . Returns
- 5. State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average : Expected Return
- 6. State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average : k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(k n )*kn Expected Return
- 7. State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(k n )*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10% Expected Return
- 8. State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(k n )*kn k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14% Expected Return
- 9. The possibility that an actual return will differ from our expected return. Uncertainty in the distribution of possible outcomes. What is Risk?
- 10. What is Risk? Uncertainty in the distribution of possible outcomes. Company B return Company A return
- 11. A more scientific approach is to examine the stock’s STANDARD DEVIATION of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK. How do we Measure Risk?
- 12. = (k i - k) P(k i ) n i =1 2 Standard Deviation
- 13. Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46% n i =1 = (k i - k) P(k i ) 2
- 14. Orlando Technology, Inc. (-10% - 14%) 2 (.2) = 115.2 (14% - 14%) 2 (.5) = 0 (30% - 14%) 2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86% = (k i - k) P(k i ) 2 n i =1
- 15. Orlando Orlando Utility Technology Expected Return 10% 14% Standard Deviation 3.46% 13.86% Summary