TAILIEUCHUNG - Lecture Fundamentals of financial management: Chapter 5 - Gregory A. Kuhlemeyer, Carroll College, Waukesha

Chapter 5 - Risk and return. In this chapter we will focus our discussion on risk and return for common stock for an individual investor. The results, however, can be extended to other assets and classes of investors. In fact, in later chapters we will take a close look at the firm as an investor in assets (projects) when we take up the topic of capital budgeting. | Chapter 5 Risk and Return © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, . Carroll College, Waukesha, WI Risk and Return Defining Risk and Return Using Probability Distributions to Measure Risk Attitudes Toward Risk Risk and Return in a Portfolio Context Diversification The Capital Asset Pricing Model (CAPM) Defining Return Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment. Dt + (Pt - Pt-1 ) Pt-1 R = Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $ per share, and shareholders just received a $1 dividend. What return was earned over the past year? Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $ per share, and shareholders just received a $1 dividend. What return was earned over the past year? $ + ($ - $ ) $ R = = 5% Defining Risk What rate of return do you expect on your investment (savings) this year? What rate will you actually earn? Does it matter if it is a bank CD or a share of stock? The variability of returns from those that are expected. Determining Expected Return (Discrete Dist.) R = S ( Ri )( Pi ) R is the expected return for the asset, Ri is the return for the ith possibility, Pi is the probability of that return occurring, n is the total number of possibilities. n i=1 How to Determine the Expected Return and Standard Deviation Stock BW Ri Pi (Ri)(Pi) .10 .20 .09 .40 .036 .21 .20 .042 .33 .10 .033 Sum .090 The expected return, R, for Stock BW is .09 or 9% Determining Standard Deviation (Risk Measure) s = S ( Ri - R )2( Pi ) Standard Deviation, s, is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. Note, this is for a discrete distribution. n i=1 How to Determine the .

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