Lecture Handouts for Chapter 5
Chapter 5 is covered in lectures 31 and 32.
Risk and Return
The return from an investment is the change in market price, plus any cash payments received due to ownership, divided by the beginning price. The risk of a security can be viewed as the variability of returns from those that are expected.
Measurement of Risk
The expected return is simply a weighted average of the possible returns, with the weights being the probabilities of occurrence.
The conventional measure of dispersion, or variability, around an expected value is the standard deviation σ. The square of the standard deviation σ2 is known as the variance (σ2).
The standard deviation can sometimes be misleading in comparing the risk, or uncertainty, surrounding alternative investments if they differ in size. To adjust for the size, or scale, problem, the standard deviation can be divided by the expected return to compute the coefficient of variation (CV) – a measure of “risk per unit of expected return.”
Investor’s Attitude towards Risk
Investors have different attitudes while deciding between the risk and return in an investment. Investors are, by and large, risk averse. This implies that they demand a higher expected return, the higher the risk.
The expected return from a portfolio
The expected return from a portfolio (or group) of investments is simply a weighted average of the expected returns of the securities comprising that portfolio. The weights are equal to the proportion of total funds invested in each security. (The weights must sum to 100 percent.)
Covariance
The covariance of the possible returns of two securities is a measure of the extent to which they are expected to vary together rather than independently of each other. For a large portfolio, total variance and, hence, standard deviation depend primarily on the weighted covariances among