Study Note Risk and Return
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sn nStudy Note Risk and Return
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sn nStudy Note: Part 2, Chapter 8 - Risk and Return
Chapter 8 of the Financial Management textbook focuses on the concepts of risk and return in
finance. It emphasizes that finance operates in a "two-parameter world" where investors aim to
maximize returns while minimizing risk.
Profits represent the dollar amount gained from an investment. It's calculated as the
difference between the investment's initial cost and its final value, including any
distributions received during the holding period.
Return quantifies the percentage change or the gain (or loss) relative to the investment
cost. Returns are usually expressed on an annual basis to facilitate comparisons between
investments held over varying durations.
o To convert a holding period return (HPR) to an annualized return, you can use
simple interest (like APR) or compound interest (like EAR).
Risk is defined as the potential for losses and the uncertainty surrounding future returns.
o A common way to quantify risk is standard deviation, which measures the
dispersion of possible outcomes around the expected return. A higher standard
deviation indicates greater volatility and risk.
o Beta is another measure of risk that specifically quantifies systematic risk - the
risk inherent to the entire market or a particular market segment that can't be
eliminated through diversification. Beta measures how sensitive an asset's returns
are to market movements.
Diversification involves distributing investments across various assets to reduce overall
risk.
o This strategy is effective in mitigating unsystematic risk (company-specific or
industry-specific risk) but not systematic risk (market-wide risk).
The Security Market Line (SML) is a graphical representation of the relationship
between risk (measured by beta) and expected return. Assets plotting above the SML are
considered undervalued, while those below are overvalued.
The Capital Asset Pricing Model (CAPM) uses the SML to calculate an asset's
expected return based on its beta and the market risk premium. The risk-free rate
represents the intercept of the SML.
Chapter 8 also provides examples and problems for calculating returns, standard deviations,
expected returns, and using the CAPM to make investment decisions.
