Topic 3. Introduction to risk and rates of return 2 per pg

Introduction to Risk and Return

• Objectives:

  • Examine the relationship between average returns and risk levels.

  • Assess the influence of inflation on returns.

  • Analyze the term structure of interest rates.

  • Define and evaluate investment return and risk.

  • Investigate the impact of diversification on portfolio risk and returns.

Risk Assessment

• Risk: Potential variability in future cash flows, measurable by standard deviation of expected returns.

  • Default Risk: Risk of borrower failing to repay debt.

  • Risk Premium: Additional return for taking on risk.

Effects of Inflation on Returns

• Fisher Effect: Relationship between nominal rates, real rates, and inflation.

  • Formula: 1 + i = (1 + R)(1 + r)

  • Explained terms:

    • i = Nominal interest rate

    • R = Real interest rate

    • r = Rate of inflation

  • Nominal Rate: Return without inflation consideration.

  • Real Rate: Adjusted nominal rate accounting for inflation.

Measuring Returns

• Historical Return: Returns already produced over a period.

• Expected Return: Anticipated return over future periods.

• Required Return: Return required by investors for consideration in an asset.

• Holding Period Return: Calculated to assess property investment returns over time.

Portfolio Risk

• Portfolio Theory: Assumes investments are evaluated through expected return and risk probabilities.

  • Portfolio Return (Rp): Weighted average of all expected returns in a portfolio.

  • Portfolio Risk: Depends on investment proportion, individual asset risk, and correlation between assets.

Diversification Benefits

• Reduced risk with increased asset correlation.

• Portfolio variance decreases with more assets, focusing on covariance impacts.

• Systematic (non-diversifiable) vs. Unsystematic (diversifiable) risks.

Measuring Market Risk

• Beta: Indicator of investment volatility relative to market.

  • Beta > 1 indicates higher volatility than the market.

  • Beta < 1 indicates lower volatility.

• Calculating a portfolio's beta involves weighing individual asset betas by investment proportions.

Capital Asset Pricing Model (CAPM)

• CAPM Formula: Rj = Rf + βj (Rm – Rf)

  • Rj: required return on security.

  • Rf: risk-free rate.

  • βj: investment's beta.

  • Rm: market return.

• Example application to calculate XYZ's expected return.

Limitations of CAPM

• Inconsistent risk-return relationships.

• Challenges in measuring beta accurately

• Questions regarding the sufficiency of market sensitivity as a risk indicator.

• Consideration of alternative models such as Arbitrage Pricing Theory.