Weeks 5& 6 - Weeks 5 6 Lecture 7 Risk(Uncertainty and Return Risk preferences 1 Risk taker will always take the riskier investment even with the

Weeks 5& 6 - Weeks 5 6 Lecture 7 Risk(Uncertainty and...

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Weeks 5 & 6 Lecture 7: Risk (Uncertainty) and Return Risk preferences: 1. Risk taker: will always take the riskier investment even with the same return 2. Risk indifferent: doesn’t care about risk if the return is equal 3. Risk adverse: will take the smallest amount of risk given the same return How can you measure risk? 1) Probability Distributions – calculate the expected value (return) and standard deviation. Ex.) Builtrite is considering the following two mutually exclusive projects: (one or the other, not both) Project A: Belief Cash Flow Prob Weighted Average Pessimistic 40 x .20 = 8 Most likely 45 .60 27 Optimistic 50 .20 10 Expected return = 45 Project B: Belief Cash Flow Prob Weighted Average Pessimistic 0 x .20 = 0 Most likely 45 .60 27 Optimistic 110 .20 22 Expected return = 49 Which project should be picked? Which project has less risk? Project A has less risk Which project has more variability (risk)? Project B is riskier We measure variability by the standard deviation “ σ “ Standard deviation A = sqrt( ((40-45)squared*.20)+((45-45)squared*.6)+((50-45)squared*.20))= 3.16
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Diversification and risk - Total risk = diversifiable risk + nondiversifiable risk “company specific” + “market risk” “unsystematic risk” + “systematic risk” Lawsuits war Strikes inflation - By diversifying, we can reduce “company specific” risk, but not market risk.
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