Risk & Return

Risk is like pornography. It is hard to define but you know it when you see it.

John Wachowicz

Return

• Dividend/ Coupon

Current yield

• Capital gains

• Return = (Divt + ( Pt – Pt-1))/ Pt-1

Risk• Actual return is different from expected return• A random variable subject to a probability

distribution• Possible scenarios• Returns in each of those scenarios• Mean and standard deviation• Attitude towards risk – Risk averse investors• Return and risk in a portfolio context• Systematic and unsystematic risk• Concept of risk premium

Return Variability

A B C

Investment A: noreturn variation,no risk

Investment B: some return variation, somerisk

Investment C:wide returnvariation, muchrisk

4.0% 2.5%

6.00%

15%

-8%

• ..\Copy of Risk_in_FM.xls

1926-2000 Average Annual Std Rate of Return Dev

Treasury Bills 3.9 3.2 Government Bonds 5.7 9.4 Corporate Bonds 6.0 8.6 Common Stocks 13.0 20.2 Small-firm stocks 17.3 33.2

Capital Asset Pricing Model

• The expected risk premium varies in direct proportion to beta.

• The security market line

r = rf + (rm – rf )

• Expected risk premium = beta * expected risk premium on the market