2023 Risk and Return
2023 Risk and Return
2023 Risk and Return
TCH 302
Cecchetti, Chapter 5
1
Introduction
• Everyday decisions involve financial and
economic risk.
2
Defining Risk
• Dictionary definition, risk is “the possibility of
loss or injury.”
4
Possibilities, Probabilities, and
Expected Value
• Probability theory states that considering
uncertainty requires:
7
Example 2
• What if the $1,000 Investment could:
Lecture 1 8
Variance and Standard Deviation
9
Measures of Risk
• The wider the range of outcomes, the greater the risk.
Measuring the spread allows us to measure the risk -
variance and standard deviation.
10
Variance and Standard Deviation
• Variance is the average of the squared deviations of
the possible outcomes from their expected value,
weighted by their probabilities.
11
Variance and Standard Deviation
• 1. Compute the expected value: ($1400 x ½) + ($700 x ½) =
$1,050.
13
Leverage and Risk and Return
• Leverage is the practice of borrowing (using debt) to
finance part of an investment.
14
Value at Risk
• Sometimes we are less concerned with spread than
with the worst possible outcome
15
Value at Risk
16
Idiosyncratic and Systematic Risk
18
Risk Aversion, the Risk
Premium, and the Risk-Return
Tradeoff
• Most people do not like risk and will pay to avoid it, most of us are
risk averse. Insurance is a good example of this.
19
Hedging Risk
• Results of Possible Investment
20
Reducing Risk through
Diversification
• Idiosyncratic risk can be reduced through
diversification, the principle of holding
more than one risk at a time.
21
Spreading Risk
22
Excercise
• Assume that the economy can experience high growth, normal
growth, or recession. Under these conditions, you expect the
following stock market returns for the coming year:
State of the Economy Probability Return
23