Chapter 13 Risk and Return 0
0 Chapter 13 Risk and Return
Chapter Outline Expected Returns and Variances ■Portfolios Announcements,Surprises,and Expected Returns Risk:Systematic and Unsystematic Diversification and Portfolio Risk a Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital:A Preview
1 Chapter Outline n Expected Returns and Variances n Portfolios n Announcements, Surprises, and Expected Returns n Risk: Systematic and Unsystematic n Diversification and Portfolio Risk n Systematic Risk and Beta n The Security Market Line n The SML and the Cost of Capital: A Preview
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 2
2 Key Concepts and Skills n Know how to calculate expected returns n Understand the impact of diversification n Understand the systematic risk principle n Understand the security market line n Understand the risk-return trade-off
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 E(R)=∑p,R i=l
3 Expected Returns n Expected returns are based on the probabilities of possible outcomes n In this context, “expected” means “average” if the process is repeated many times n The “expected” return does not even have to be a possible return n i E R piRi 1 ( )
Example:Expected Returns Suppose you have r predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession ?? 0.02 0.01 Rc=.3(.15)+.5(.10)+.2(.02)=.099=9.9% RT=.3(.25)+.5(.20)+.2(.01)=.177=17.7% 4
4 Example: Expected Returns n Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.9% RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7% State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession ??? 0.02 0.01