### Essay preview

Chapters 10 and 11: Lessons from Capital Market History & Risk and Return

1. Purpose of the chapters:

a) Understand risk and return of major asset classes

b) Understand of how risk affects r (interest rate).

Nature of Risk?

_____________________________________________________________________________ _____________________________________________________________________________

2. Nominal r for a risky investment has three components:

a) Nominal r = __________________________________________________________________

b) real riskless rate is dependent on supply and demand of money available for similar investments, represents the ________________________.

c) premium for expected inflation is termed the _________________ effect.

d) risk premium - focus of these two chapters.

Higher the risk, the higher the ex-ante required rate of return (interest rate). We need to know how to

i) _____________ the amount of risk an investment has.

ii) Decide how much ___________________________ is required to compensate for the risk.

3. a) Asset Class Performance ______________

What does a higher average return imply?

How much should you trust historical averages to predict future performance? Future value of investments in asset classes (See Text Figure 10.4): Year ____________value of a $1 investment made in ______ in various alternatives & inflation effect: T-bills

T-bonds

S&P500

Small Stocks (growth stocks)

Do stocks outperform bonds in all time periods? ______________________________

Implication? ____________________________________________

3. b) Aggregate risk premiums (simplest approach to measuring the risk premium):

Method:

Compare ___________________________ rates of return on risky securities to the _____________________________ rate of return on risk free securities over the same period

and ______________ the two to get a rough idea of the risk premium for that type of risky security.

Normally the ___________ is used as the risk free rate of return. Why? Call this rate "Rf" or “rf”

3. c) Historical aggregate risk premium data and real returns ____________________

Large Stock risk premium:

r for large stocks? Current T-bill rate = __________

Historical real return for large stocks?

Small Stock risk premium:

r for small stocks?

Historical Real return for Long Term Government Bonds?

Historical real return T-bills?

Problems with this approach to measuring r?

1. ____________________________________________________________________

2. _________________________________________

3. _________________________________________

4. Risk: Defined and Quantified:

a) Defined: Potential for getting outcomes (___________rates of return) which are different from the ____________ outcome.

b) For a stock the annual rate of return is given by:

BUT this really should be written as:

where E[ ] means "expected." Why?

Risk is then the possibility that ___________________________________________________

OR: Realized r = ____________________________

where ____ stands for “____________________” events that affect the rate of return.

c) How can we measure how far from the expected outcome the actual outcome is likely to be?

Is there a statistic which measures the distribution of outco...

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