Risk And Rates Of Return, Lecture Notes - Financial Management, Study notes for Financial Management. University of Michigan (MI)

Financial Management

Description: All Financial Assets Produce CFs, Risk of Asset Depends on Risk of CFs, Stand-alone Risk of Asset’s CFs, Portfolio Risk of CFs , Diversifiable and Market Risk, Risk
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CHAPTER 8: Risk and Rates of Return
Updated: September 20, 2011
All Financial Assets Produce CFs
Risk of Asset Depends on Risk of CFs
Stand-alone Risk of Asset’s CFs
Portfolio Risk of CFs
Diversifiable and Market Risk
Risk & return: CAPM / SML
Investment returns
The rate of return on an investment can be
calculated as follows:
(Amount received Amount invested)
Return = ________________________
Amount invested
For example, if $1,000 is invested and $1,100 is
returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.
What is investment risk?
Two types of investment risk
Stand-alone risk
Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than expected
or negative returns, the riskier the investment.
Risk = Dispersion of Returns around mean, or
expected mean: variance or standard deviation
Probability distributions
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Expected Rate of Return
Rate of
Return (%)
100 15 0 -70
Firm X
Firm Y
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