Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Chapter 13,Return,Risk,and,the Security Market Line,McGraw-Hill/Irwin,Copyright 2013 by The McGraw-Hill Companies,Inc.All rights reserved.,Chapter 13McGraw-Hill/IrwinCop,Key Concepts and Skills,Know how to calculate expected returns,Understand the impact of diversification,Understand the systematic risk principle,Understand the security market line,Understand the risk-return trade-off,Be able to use the Capital Asset Pricing Model,13-,2,Key Concepts and SkillsKnow ho,Chapter Outline,Expected Returns and Variances,Portfolios,Announcements,Surprises,and Expected Returns,Risk:Systematic and Unsystematic,Diversification and Portfolio Risk,Systematic Risk and Beta,The Security Market Line,The SML and the Cost of Capital:A Preview,13-,3,Chapter OutlineExpected Return,Expected Returns,Expected returns are based on the probabilities of possible outcomes,In this context,“expected”means average if the process is repeated many times,The“expected”return does not even have to be a possible return,13-,4,Expected ReturnsExpected retur,Example:Expected Returns,StateProbabilityCT,Boom0.31525,Normal0.51020,Recession?2 1,R,C,=.3(15)+.5(10)+.2(2)=9.9%,R,T,=.3(25)+.5(20)+.2(1)=17.7%,13-,5,Suppose you have predicted the following returns for stocks C and T in three possible states of the economy.What are the expected returns?,Example:Expected ReturnsStat,Variance and Standard Deviation,Variance and standard deviation measure the volatility of returns,Using unequal probabilities for the entire range of possibilities,Weighted average of squared deviations,13-,6,Variance and Standard Deviatio,Example:Variance and Standard Deviation,Consider the previous example.What are the variance and standard deviation for each stock?,Stock C,2,=.3(15-9.9),2,+.5(10-9.9),2,+.2(2-9.9),2,=20.29,=4.50%,Stock T,2,=.3(25-17.7),2,+.5(20-17.7),2,+.2(1-17.7),2,=74.41,=8.63%,13-,7,Example:Variance and Standard,Another Example,Consider the following information:,StateProbabilityABC,Inc.(%),Boom.2515,Normal.508,Slowdown.154,Recession.10-3,What is the expected return?,What is the variance?,What is the standard deviation?,13-,8,Another ExampleConsider the fo,Portfolios,A portfolio is a collection of assets,An assets risk and return are important in how they affect the risk and return of the portfolio,The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation,just as with individual assets,13-,9,PortfoliosA portfolio is a col,Example:Portfolio Weights,Suppose you have$15,000 to invest and you have purchased securities in the following amounts.What are your portfolio weights in each security?,$2000 of C,$3000 of KO,$4000 of INTC,$6000 of BP,C:2/15=.133,KO:3/15=.2,INTC:4/15=.267,BP:6/15=.4,13-,10,Example:Portfolio WeightsSupp,Portfolio Expected Returns,The expected return of a portfolio is the weighted average of the expected returns of the respective assets in the portfolio,You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities,13-,11,Portfolio Expected ReturnsThe,Example:Expected Portfolio Returns,Consider the portfolio weights computed previously.If the individual stocks have the following expected returns,what is the expected return for the portfolio?,C:19.69%,KO:5.25%,INTC:16.65%,BP:18.24%,E(R,P,)=.133(19.69)+.2(5.25)+.267(16.65)+.4(18.24)=15.41%,13-,12,Example:Expected Portfolio Re,Portfolio Variance,Compute the portfolio return for each state:R,P,=w,1,R,1,+w,2,R,2,+w,m,R,m,Compute the expected portfolio return using the same formula as for an individual asset,Compute the portfolio variance and standard deviation using the same formulas as for an individual asset,13-,13,Portfolio VarianceCompute the,Example:Portfolio Variance,Consider the following information,Invest 50%of your money in Asset A,StateProbabilityAB,Boom.430%-5%,Bust.6-10%25%,What are the expected return and standard deviation for each asset?,What are the expected return and standard deviation for the portfolio?,Portfolio,12.5%,7.5%,13-,14,Example:Portfolio VarianceCon,Another Example,Consider the following information,StateProbabilityXZ,Boom.2515%10%,Normal.6010%9%,Recession.155%10%,What are the expected return and standard deviation for a portfolio with an investment of$6,000 in asset X and$4,000 in asset Z?,13-,15,Another ExampleConsider the fo,Expected vs.Unexpected Returns,Realized returns are generally not equal to expected returns,There is the expected component and the unexpected component,At any point in time,the unexpected return can be either positive or negative,Over time,the average of the unexpected component is zero,13-,16,Expected vs.Unexpected Return,Announcements and News,Announcements and news contain both an expected component and a surprise component,It is the surprise component that affects a stocks p