FINE 3200 Lecture Notes - Lecture 4: Arsenic, Sharpe Ratio, Standard Deviation

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23 May 2017
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The expected cash flow is (. 5 ,000) + (. 5 200,000) = ,000. With a risk premium of 8 percent over the risk-free rate of 6 percent, the required rate of return is 14 percent. Therefore, the present value of the portfolio is. ,000/1. 14 = ,421: if the portfolio is purchased for ,421, and provides an expected cash inflow of ,000, then the expected rate of return [e(r)] is derived as follows: The portfolio price is set to equate the expected rate of return with the required rate of return: if the risk premium over t-bills is now 12 percent, then the required return is. The present value of the portfolio is now. ,000/1. 18 = ,407: for a given expected cash flow, portfolios that command greater risk premiums must sell at lower prices. The extra discount from expected value is a penalty for risk.

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