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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.