Chapter 6
Rate of Return Pg. 237
(amount received - amount invested) / amount invested -- The rate of return calculation"standardizes"the dollar return by considering the annual return per unit of investment.
How to determine the STANDARD DEVIATION Pg. 240
1. Calculate the expected value for the RETURN (probability * decimal of expected return) 2. Subtract the expected return from each possible outcome (ri/RETURN) 3. Square each deviation, then multiply the squared deviations by the (decimal) probability of occurrence. Sum these to obtain VARIANCE 4. Take the square root of Variance to obtain the standard deviation. -- High beta (usually goes with a high standard deviation), which means that it contributes a lot of risk to a portfolio
Return on a Portfolio
1. Find the weighted average. - Divide original value $/ total value of new shares $ 2. Determine the RETURN Add together the = probability * decimal of expected return (for each possible economic outcome)
Risk Premium for an Individual Stock (RPi) Pg. 258
= Beta * Market Risk Premium
Market Risk Premium Pg. 258
= required return of the market - risk free rate -- the extra rate of return that investors require to invest in the stock market rather than purchase risk-free securities
Expected Rate of Return Pg. 239
= sum (Possible outcome * Probability) -- The result is the weighted average of outcomes.
Relevant Risk Pg. 250
A stocks contribution to a well diversified portfolio's risk
Required Return (on stock) Pg. 258
Risk free rate + beta * market risk premium or Risk free rate + Risk premium (for stock) which is .... ((beta*(required rate of return - risk free))
SML (Security Market Line) Pg. 257
Shows that a stock's risk premium is = to the product of the stock's beta and the market risk premium
Risk Free Rate of Return Pg. 258
The interest an investor would expect from an absolutely risk-free investment
Beta Pg. 251
The relevant measure of risk -- High beta (usually goes with a high standard deviation), which means that it contributes a lot of risk to a portfolio -- The weighted average of the betas of the stocks in the portfolio, with the weights equal to the same weights used to create the portfolio.
Expected Return on a Portfolio Pg. 262
The weighted average of the expected returns on the individual assets in the portfolio
Required Return on a Portfolio Pg. 262
The weighted average of the required returns on the individual assets in the portfolio rp =Risk free rate of return + (portfolio beta * market risk premium)
Diversifiable Risk Pg. 249
lawsuits, strikes, successful & unsuccessful market programs
To calculate a return for stock in an economy with "5 possible states".
rp
Market Risk Pg. 249
war, inflations, recessions, & high interest rates
How to determine the RETURN Pg. 240
Add together the = probability * decimal of expected return (for each possible economic outcome)
Correlation & Correlations Coefficient Pg. 247
Correlation - The tendency of two variables to move together Coefficient - Measures this tendency. -- Can range from +1.0 ( variables, perfect synchronization) to -1.0 (variables, move in opposite directions, 0 (variables, not related)
CAPM (Capital Asset Pricing Model) Pg. 250
Defines the relevant risk of an individual stock as the amount of risk that the stock contributes to the market portfolio
Average
Excel: AVERAGE
Standard Deviation
Excel: STDV -- A high standard deviation (tends to have a high beta), which means the stoke contributes a lot of risk
Notation
^ri : Expected rate of return on stock i ri aka RETURN: Required rate of return on stock i. This is the minimum expected return that is required to induce an average investor to purchase the stock. -r (- is over the r) : Realized, after the fact return rRF : Risk free rate of return. In this context, rRF is generally measured by the expected return on long-term U.S. Treasury bonds bi: Beta coefficient of stock i. rM : Required rate of return on a portfolio consisting of all stocks aka Market Portfolio RPi: Risk premium on stock i: RPi = bi (RPm) RPm: Risk premium on "the market." RPm = (rm - rRF) is the additional return over the risk free rate required to induce an average investor to invest in the market portfolio.
