1.
All financial assets are expected to produce (1) on a stand-alone basis, where
cash flows, and the riskiness of an asset is
judged in terms of the riskiness of its cash
flows.
2. The riskiness of an asset can be considered
in two ways:
1) on a standalone basis, where the
asset’s cash flows are analyzed by themselves,
or
2) in a portfolio context, where the cash
flows from a number of assets are combined,
and then the consolidated cash flows are
analyzed.
There is an important difference between
stand-alone and portfolio risk, and an asset that
has a great deal of risk if held by itself may be
much less risky if it is held as part of a larger
portfolio.
3. In a portfolio context, an asset’s risk can be
divided into two components:
(a) diversifiable risk, which can be
diversified away and thus is of little concern to
diversified investors, and
(b) market risk, which reflects the risk of a
general stock market decline and which cannot
be eliminated by diversification, hence does
concern investors. Only market risk is relevant
—diversifiable risk is irrelevant to rational
investors because it can be eliminated.
4. An asset with a high degree of relevant
(market) risk must provide a relatively high
expected rate of return to attract investors.
Investors in general are averse to risk, so they
will not buy risky assets unless those assets
have high expected returns.
DOLLAR RETURN
Dollar return = Amt received - Amt invested
TWO PROBLEMS:
(1) Scale (size) and (2) Timing Problem
RATES OF RETURN OR PERCENTAGE
RETURNS
= Amt Received – Amt Invested
Amt Invested
= Dollar Return
Amt Invested
The rate of return calculation “standardizes”
the return by considering the return per unit of
investment. The most common measure of
investment performance.
RISKS - The chance that some unfavorable
event will occur.
Asset’s risk can be analyzed in two ways:
the asset is considered in isolation, and
(2) on a portfolio basis, where the asset
is held as one of a number of assets in a portfolio
PROBABILITY is defined as the chance that the
event will occur.
PROBABILITY DISTRIBUTION - A listing of all
possible outcomes, or events, with a probability
(chance of occurrence) assigned to each
outcome.
Expected Rate of Return, kˆ (“k-hat”) - The
rate of return expected to be realized from an
investment; the weighted average of the
probability distribution of possible results.
Expected rate of return = kˆ = P1k1 + P2k2 +. . .
+ Pnkn
ki is the ith possible outcome, Pi is the probability
of the ith outcome, and n is the number of
possible outcomes. Thus, kˆ is a weighted
average of the possible outcomes (the ki values),
with each outcome’s weight being its probability
of occurrence.
The tighter, or more peaked, the probability
distribution, the more likely it is that the actual
outcome will be close to the expected value, and,
consequently, the less likely it is that the actual
return will end up far below the expected return.
Thus, the tighter the probability distribution, the
lower the risk assigned to a stock. Since U.S.
Water has a relatively tight probability
distribution, its actual return is likely to be closer
to its 15 percent expected return than is that of
Martin Products.
Standard Deviation (sigma)- A statistical
measure of the variability of a set of observations.
-The smaller the standard deviation, the tighter
the probability distribution, and, accordingly, the
lower the riskiness of the stock.
MEASURING STAND-ALONE RISK:
THE COEFFICIENT OF VARIATION