Risk-Return Relationship
CHAPTER 22
estimating risk and return on assets
1. WHAT IS RISK?
Risk is the variability of an asset’s future returns. When only one return is possible, there is no risk. When more than one return is possible, the asset is risky. The greater the variability, the greater the risk.
2. RISK – RETURN RELATIONSHIP
Investment risk is related to the probability of actually earning less than the expected return – the greater the chance of low or negative returns, the riskier the investment. Investors take on higher risk investments in expectation of earning higher returns. Of course taking risk also means that the investor does not guarantee that the investment will be recovered.
3. PROBABILITY AND PROBABILITY DISTRIBUTION
Probability – is the percentage chance that an event will occur. It range between 0 and 1.0.
Probability Distribution – If all possible events or outcomes are listed and the probability is assigned to each event, the listing is called a probability distribution. It may be :
An objective probability distribution is generally based on past outcomes of similar events while asubjective probability distribution is based on opinions or “educated guesses” about the likelihood that an event will have a particular future outcome.
But in reality, probability distribution often combine both objective and subjective probabilities.
Probability Distribution may also be:
A discrete probability distribution is an arrangement of the probabilities associated with the values of a variable that can assume a limited or finite number of values (outcomes) while a continuous probability distribution is an arrangement of probabilities associated with the values of a variable that can assume an infinite number of possible values (outcomes).
To illustrate let us answer problem No. 1
Problem 1
(a) The bar charts for Stock A and Stock B are shown in the next page.
(b) Stock A’s probability distribution is skewed to the left and Stock B’s
estimating risk and return on assets
1. WHAT IS RISK?
Risk is the variability of an asset’s future returns. When only one return is possible, there is no risk. When more than one return is possible, the asset is risky. The greater the variability, the greater the risk.
2. RISK – RETURN RELATIONSHIP
Investment risk is related to the probability of actually earning less than the expected return – the greater the chance of low or negative returns, the riskier the investment. Investors take on higher risk investments in expectation of earning higher returns. Of course taking risk also means that the investor does not guarantee that the investment will be recovered.
3. PROBABILITY AND PROBABILITY DISTRIBUTION
Probability – is the percentage chance that an event will occur. It range between 0 and 1.0.
Probability Distribution – If all possible events or outcomes are listed and the probability is assigned to each event, the listing is called a probability distribution. It may be :
An objective probability distribution is generally based on past outcomes of similar events while asubjective probability distribution is based on opinions or “educated guesses” about the likelihood that an event will have a particular future outcome.
But in reality, probability distribution often combine both objective and subjective probabilities.
Probability Distribution may also be:
A discrete probability distribution is an arrangement of the probabilities associated with the values of a variable that can assume a limited or finite number of values (outcomes) while a continuous probability distribution is an arrangement of probabilities associated with the values of a variable that can assume an infinite number of possible values (outcomes).
To illustrate let us answer problem No. 1
Problem 1
(a) The bar charts for Stock A and Stock B are shown in the next page.
(b) Stock A’s probability distribution is skewed to the left and Stock B’s