Risk and Return Part 1

• what makes something risky

  uncertainty ( multiple possible outcomes)

  possible loss ( at least one outcome bad)
• Need what to be consider risky

  uncertainty and possible loss
• Greater variability = 


  greater risk
• Percentage Return

  R = ((P1 + CF) / P0) - 1
• Percentage of Return is

  a holding period return no time dimension
• CF =


  dividends
• bought stock for $50 last year, paid a dividend of $2.00, currently priced at $43. what is your return?

  -10%
• Expected Return E(R)


  what you think you'll get

  most likely outcome
• Expected Return is determined by

  expected future cash flows

  price (current)
• EFCF increases

  price increases
• Price increases

  EFCF decreases
• Required Return

  what you need to get

  minimum level of return to cause investment
• Required Return is determined by

  risk

  other available opportunities
• Risk

  higher risk <-> higher required return
• Other available opportunities

  same risk -> same return
• Required Return formula

  Required Return = risk-free rate + risk premium
• Risk-Free rate

  no risk

  its guarantee
• Risk Premium

  extra return for risk
• How often would E(R) and Required Return are equal for a given security

  always
• Stock will pay 15% this year and for the same risk everything is 12%

  will buy (done be everyone as well)

  price increases

  E(R) decreases

  stop at 12%
• stock will pay you 10% this year and for the same risk everything else only pays 12%

  sell ( done by everyone as well)

  price decreases

  E(R) increases

  it will stop at 12%
• Expected Return = Required Return


  stock is in equilibrium
• Stock is in equilibrium at

  any given time (no incentive to change)
• Do prices change in our market, and how often?

  yes

  all the time
• Why do prices change constantly?

  new information changes expected and or required return

  price must change to restore equilibrium
• Expected Return

  E P1 * R1
• Standard Deviation


  SQ E(Ri-E(R))^2 * Pi)
• Recess .25 5%

  Normal .50 15%

  Expand .25 25%

  E(R) = 15%
• Recess .25 40%

  Normal .50 15%

  Expand .25 -5%

  E(R) = 16.25%
• Recess .25 5%

  Normal .50 15%

  Expand .25 25%

  E(R) `15%

  O^ = 7.07%
• Risk Adverse

  dislike risk -> doesn't me you won't take risk

  everyone is risk adverse at some point
• Risk Adverse part 2

  that you need more return if you take more risk
• A risk investor will

  seek to maximize return for given risk

  OR

  seek to minimize risk for given return
• More risk-averse


  require greater return for a given risk
• One security dominates is

  one stock is preferred by every risk-averse investor
• Security Dominates stock

  if it has higher return for the same or less risk

  OR

  if it has less risk for the same or higher return
• It has to

  obvious

  it means that one is better

  to be considered a dominate security