Chapter Five discusses the concepts of risk, return, and risk preferences in investments. It explains how to measure risk and return for single assets and portfolios, including the use of standard deviation and coefficient of variation. The chapter also covers the Capital Asset Pricing Model (CAPM) and the factors that influence shifts in the Security Market Line (SML).
Chapter Five discusses the concepts of risk, return, and risk preferences in investments. It explains how to measure risk and return for single assets and portfolios, including the use of standard deviation and coefficient of variation. The chapter also covers the Capital Asset Pricing Model (CAPM) and the factors that influence shifts in the Security Market Line (SML).
Chapter Five discusses the concepts of risk, return, and risk preferences in investments. It explains how to measure risk and return for single assets and portfolios, including the use of standard deviation and coefficient of variation. The chapter also covers the Capital Asset Pricing Model (CAPM) and the factors that influence shifts in the Security Market Line (SML).
Chapter Five discusses the concepts of risk, return, and risk preferences in investments. It explains how to measure risk and return for single assets and portfolios, including the use of standard deviation and coefficient of variation. The chapter also covers the Capital Asset Pricing Model (CAPM) and the factors that influence shifts in the Security Market Line (SML).
Chapter Outline: 1. The Meaning of Risk, Return, and Risk Preferences. 2. Measuring Risk and Return for a Single Asset. 3. Measuring Risk and Return for a Portfolio. 4. The Types of Risk and the Role of Beta in Measuring the Relevant Risk. 5. The Capital Asset Pricing Model (CAPM) and its Relationship to the Security Market Line (SML). 6. The Major Forces Causing Shifts in the Security Market Line (SML) [1] THE MEANING OF RISK, RETURN, AND RISK PREFERENCES 1/1 THE MEANING OF RISK, RETURN • Risk is a measure of the variability of returns in a given investment (asset). • Return is the total gain or loss experienced on an investment (asset) over a given period. • Return on any investment (Alternative) depends mainly on general economic conditions (Expansion, Depression, etc.). The total rate of return earned on any investment (asset) over period t, rt, can be calculated by applying the following expression; Example (1): At the beginning (Pt-1) of the year, X stock traded for EGP 50.00 per share, and Y stock was valued at EGP 30.00. During the year (Ct) , X stock paid no dividends, but Y stock paid EGP 1.20 dividends per share. At the end of the year (Pt), X stock was worth EGP 60.00 and Y sold for EGP 25.00. The annual rate of return, r, for each stock can be calculated as following. X stock: [0 + (60.00 – 50.00)] / 50.00 = 20%. Y stock: [1.20 + (25.00 – 30.00)] / 30.00 = –12.67% 1/2 RISK PREFERENCES Three categories of attitudes can be utilized to describe how investors respond or to risk. These are: • Risk averse: is the attitude toward risk in which investors would ask or require for an increased return to compensate them for taking higher risk. • Risk-neutral( normal) : is the attitude toward risk in which investors choose the investment with the higher return regardless of its risk. • Risk-seeking is the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected return. 2- MEASURING RISK AND RETURN FOR A SINGLE ASSET : Example 2: Nancy Company wants to choose between two investments, (A) and (B). - Each asset requires an initial investment EGP100, 000 . -the risk range of asset A is 25% , and the risk range of asset B is 38%. 1- Expected return (r̄) is the average returns that an asset is expected to produce over time. 2- MEASURING RISK: STANDARD DEVIATION, COEFFICIENT OF VARIATION 1-Standard deviation is statistical indicator of an asset’s risk; it measures the distribution around the expected value. The formula for the standard deviation of returns is; 2-Coefficient of Variation (CV) The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns. • The coefficient of variation, CV, can be calculated using the following expression:
- A higher coefficient of variation means that an investment has more volatility relative to its expected return. Example: Using the standard deviations and the expected returns for assets A and B to calculate the coefficients of variation yields the following: CVA = 8.56%÷ 4.10%= 2.09 = 209%. CVB = 13.94%÷ 12.10%= 1.15 = 115%. This means asset return risk A 1 2.09 B 1 1.15 - results indicate that asset A is riskier than asset B. - asset A is riskier than asset B. A wise investor then will choose asset B over asset A.
Note that: Coefficient of variation is a relative measure of risk while standard
deviation is an absolute measure. That’s why, after calculating standard deviation we need to relay on the calculation of coefficient of variation to compare between investment alternatives.
