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Chapter 2 FUNDAMENTALS OF RISK AND RETURN • What are the sources of investment returns? • How are investment returns measured? • What is investment risk and how is it measured? • How are risk and return measured for portfolios of assets? • Why does diversification benefit investors? • What is the relationship between risk and required return? Contemporary Investments: Chapter 2 Sources of investment returns • Income • Interest • Dividends • Price changes: Capital gains or Capital losses • Paper gains and losses • Ex-ante and ex-post returns Contemporary Investments: Chapter 2 Measuring investment returns • Calculating holding period returns • Breaking down returns between income and capital gains • Calculating expected returns • Inflation adjusted returns • International returns • Total return indexes Contemporary Investments: Chapter 2 Investment History –The Agony of Bond Investors: 1965-1981 Contemporary Investments: Chapter 2 Figure 2.1 – Total Return Index for Johnson & Johnson: 1991-2001 Contemporary Investments: Chapter 2 Summarizing returns • Arithmetic mean • Annualizing the arithmetic mean • Geometric mean • Comparing the geometric and arithmetic means Contemporary Investments: Chapter 2 Investment risk • A definition of risk: uncertainty of return • Types (sources) of risk • Default, Credit, Tax, Interest Rate, Market, Event, Liquidity, Foreign Exchange • Measuring risk • Calculating a standard deviation • Annualizing a standard deviation Contemporary Investments: Chapter 2 Figure 2.2 – Probability of Possible Return Contemporary Investments: Chapter 2 Figure 2.3 – Stock and T-Bill Returns: 1982-2001 Contemporary Investments: Chapter 2 Figure 2.4 – Monthly Returns for 3M and Starbucks Contemporary Investments: Chapter 2 Risk, return and investment selection • Portfolio risk and return • Finding the mean return of a portfolio • Finding the standard deviation of a portfolio • Correlation coefficient Contemporary Investments: Chapter 2 Figure 2.5 – Monthly Returns for Dow Chemical and Verizon Communication Contemporary Investments: Chapter 2 Diversification • Naïve versus efficient diversification • Diversifiable versus non-diversifiable risk • Diversifiable or unsystematic risk • Non-diversifiable or systematic risk • Beta • Risk and required return Contemporary Investments: Chapter 2 Figure 2.6 – Real and Nominal Returns on T-Bills: 1981-2001 Contemporary Investments: Chapter 2 Figure 2.7 – Yields on T-Bills, T-Bonds, and Baa Corporate Bonds: 1988-2002 Contemporary Investments: Chapter 2

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