Lessons from Capital Market History and Risk and Return

Nature of Risk
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Terms in this set (16)
Nature of Risk
Return you actually earned (realize) is different from return you expected to earn
Nominal r for a risky investment has 3 components:
1. Nominal r= real riskless rate + Expected inflation premium + risk premium
Real riskless rate
is dependent on supply and demand of money available for similar investments
Fisher Effect (exact and approx.)
Premium for expected inflation
Higher the risk.....
Higher the interest rate
With a risk premium we need to know how to:
1. Quantify the amount of risk an investment has
2. Decide how mud additional return is required to compensate for the risk.
What does a higher average return imply?
Higher Risk
Do stocks out perform bonds in all time periods?
No
Implications of stocks and bonds performing together
Investors should have BOTH
What is the simplest approach to measuring the risk premium?
Aggregate risk premiums
Aggregate Risk PremiumsCompare Historical average rates of return on risky securities to the historical average rate of return free securities over the same period and SUBTRACT the two to get a rough idea of the risk premium for that type of risky security.T-Bill RateIs normally used as the risk free rate of return "rf"Problems with using aggregate risk premium1. Post data on averages (unstable over time, too high for long term forecast) 2. Appropriate time Period? 3. Gross Measure (unrefined)RiskPotential for getting outcomes (realized rates of return) which are different from the expected outcomeSystematic Risk or NondiversifiableRisk an investor cannot get rid ofUnsystematic or DiversifiableRisk an investor