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BIG QUESTION
Please give me your own simple definition of required rate of return ...
Unsystematic Systematic
Correlation
No benefit (SD = 20%) Substantial benefit (SD = 14%) Effective diversification (SD = 0%)
Average return
portfolio Wi i i = = =
SD in portfolio return
proportion of asset i in the portfolio SD in the return earned by asset i correlation coefficient (rho) between the rates of return earned by assets i and j
Interpretation of
1. As a range within which the actual returns of an investment fluctuates
Compare it to standard deviation of another investment
2.
If expected return is 15% and = 10% then: 1. There is 68% probability that the actual return will fall between 5% to 25% 2. There is 95% probability that the actual return will fall between -5% to 35% 3. There is 99% probability that the actual return will fall between -15% to 45%
Risk Profile
Investments Expected Return Standard Deviation
Investment A
Investment B Investment C
24%
20% 24%
18%
15% 15%
Risk Apetite is the willingness of an investor to bear risk: 1. Risk averse is the pattern of behaviors that have tendency to avoid risk 2. Risk neutral is the pattern of behaviors that neither have the tendency to avoid or to absorb risk 3. Risk lover is the pattern of behaviors that have tendency to absorb risk
Characteristic Line
Represents the average movement of the firms stock returns in response to a movement in the markets return (S&P 500 or IHSG) or simply stated as volatility
Beta ()
Beta menggambarkan derajat perubahan dari return suatu sekuritas terhadap perubahan return pasar (market index)
Y2
Characteristic Line
Return on security A
Y = a + (x)
Formula:
Y1
Rise
Run
X1
X2
Beta of a Portfolio
Financial Asset Treasury bill Long-term government bond Large company stock Total
kj krf km
= = = =
appropriate required rate of return of the jth security risk-free rate of return (ex. rate of Treasury Bill) expected return for the market (ex. return of S&P 500) the degree to which kj behaves in response to km
Warning
SML merupakan suatu persamaan garis lurus (Y = a + bX) dimana: Dependent variable (Y) pada SML adalah required rate of return (kj). Intercept (a) pada SML adalah Risk-free rate (krf) Slope (b) pada SML adalah (km krf) karena pada kj = km , = 2 1 = 1 0 = 0. Independent variable (X) pada SML adalah beta ().
Exercises
1. Keown et al pg. 217 problem 6-12B 2. Keown et al pg. 217 problem 6-13B