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Chapter 7

Risk and Return

Learning Objectives

1. Explain the relation between risk and return.

Investors require greater returns for taking greater risk. They prefer the investment with the highest possible return for a given level of risk or the investment with the lowest risk for a given level of return.

2. Describe the two components of a total holding period return, and calculate this return for an asset.

The total holding period return on an investment consists of a capital appreciation component and an income component. This return is calculated using Equation 7.1. It is important to recognize that investors do not care whether they receive a dollar of return through capital appreciation or as a cash dividend. Investors value both sources of return equally.

3. Explain what an expected return is, and calculate the expected return for an asset.

The expected return is a weighted average of the possible returns from an investment, where each of these returns is weighted by the probability that it will occur. It is calculated using Equation 7.2.

4. Explain what the standard deviation of returns is, explain why it is especially useful in finance, and be able to calculate it.

The standard deviation of returns is a measure of the total risk associated with the returns from an asset. It is useful in evaluating returns in finance because the returns on many assets tend to be normally distributed. The standard deviation of returns provides a convenient measure of the dispersion of returns. In other words, it tells us about the probability that a return will fall within a particular distance from the expected value or within a particular range. To calculate the standard deviation, the variance is first calculated using Equation 7.3. The standard deviation of returns is then calculated by taking the square root of the variance.

5. Explain the concept of diversification.

Diversification is a strategy of...