Risk and return

• Return

  Money earned from investment
• Risk

  Can be positive or negative active. Possibility of losing your investment money
• Expected return

  The percentage yield that an investor forecasts from a specific investment over a set period of time
• Return formula

  Return =

  
• mean return ( arithmetic average return, AR)

  Overall returns (e.g. add them or subtract if negative)/ time periods
• Compounds annual returns (Geometric return)

  CAR =

  
• Geometric average returns tells you

  what you actually earned per year on average compounded annually
• Arithmetic average Tells you

  what you earn in a typical all year
• What do you use to measure risk

  Variance

  Standard deviation
• Variance definition

  The probability weighted average value of squared deviations from the mean
• Variance formula


  Variance =

  
• standard deviation definition

  Similar measure of dispersion but with a more convenient scale
• standard deviation formula

  sd=

  
• normal distribution

  rule 68, 1sd

  95, 2sd

  99.7, 3sd

  
• If the risk/ return is positive should you invest


  Yes
• you can only compare risk if

  2 projects/investments where the risk is the same

  Select the one with the higher return
• You can only compare (return) If

  2 projects/ investments where the return is the same

  Select the one with lower risk
• Sharpe ratio definition

  Measures the number of units of additional return recieved for each additional unit of risk
• sharpe ratio formula 


  SR=

  
• risk free return definition

  the interest rate an investor can expect to earn on an investment that carries zero risk
• What does required return depend on

  The risk of the investment

  So greater the risk the greater the required return
• what is the responsibility of financial managers

  asses the value of proposed real asset investments
• two lessons from market hostory

  1. there is a reward for bearing risk
  2. the greater the potential reward is, the greatest risk
• what is the return on your investment

  if you buy an asset of any sort the gain or loss = return
• what are the two components of return

  1. cash directly - income component

  2. the value of the asset you purchase will often change
• What’s an example of systematic risk

  A sudden increase in oil prices affecting the whole economy
• Which type of risk can be reduced through diversification

  unsystematic risk
• The risk free rate in the CAPM model is typically represented by

  The yield on short term government securities
• The expected return of a portfolio is calculated as

  The weighted average of the expected returns of the individual assests
• The standard deviation of a portfolio measures

  Total risk, including both systematic and unsystematic risk
• The Sharpe ratio measures

  The excess return per unit of risk