CHAPTER TWO: RETURN AND RISK 06/08/2011 1 06/08/2011 2 RATE OF RETURN - Expected market return Rm = Rf + risk premium - Rate of Return on risky assets Re = Rf + ß(Rm – Rf) 06/08/2011 3 INTEREST Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money or money earned by deposited funds. 06/08/2011 4 TYPES OF INTEREST • The effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears. • The "real interest rate" is approximately the nominal interest rate minus the inflation rate (this can be found using the Fisher equation). It is the rate of interest an investor expects to receive after subtracting inflation. This is not a single number, as different investors have different expectations of future inflation. 06/08/2011 5 • Simple interest is calculated only on the principal amount, or on that portion of the principal amount that remains unpaid. • Compound interest is very similar to simple interest; however, with time, the difference becomes considerably larger. This difference is because unpaid interest is added to the balance due. Put another way, the borrower is charged interest on previous interest. 06/08/2011 6 RISK - Risk is an uncertainty or volatility; - Uncertainty estimated with a certain probability is called Risk. 06/08/2011 7 TYPES OF RISK - A business risk is a circumstance or factor that may have a negative impact on the operation or profitability of a given company. Sometimes referred to as company risk, a business risk can be the result of internal conditions, as well as some external factors that may be evident in the wider business community. - Financial risk is an umbrella term for any risk associated with any form of financing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return. 06/08/2011 8 TYPES OF RISK - Systematic risk: The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk" or "market risk.“ - Unsystematic risk: Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification. Also known as "specific risk", "diversifiable risk" or "residual risk". 06/08/2011 9 BASIC TERMS Portfolio: A collection of investments all owned by the same individual or organization. These investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices. Portfolio Management : The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against. performance. Portfolio management is all about strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other tradeoffs encountered in the attempt to maximize return at a given appetite for risk. . CHAPTER TWO: RETURN AND RISK 06/08/2011 1 06/08/2011 2 RATE OF RETURN - Expected market return Rm = Rf + risk premium - Rate of Return on risky assets Re = Rf + ß(Rm. umbrella term for any risk associated with any form of financing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less),. that return. 06/08/2011 8 TYPES OF RISK - Systematic risk: The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk& quot; or "market risk. “ -