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Weeks 5 & 6Lecture 7: Risk (Uncertainty) and Return Risk preferences: 1. Risk taker: will always take the riskier investment even with the same return2. Risk indifferent: doesn’t care about risk if the return is equal3. Risk adverse: will take the smallest amount of risk given the same returnHow 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 10Expected return = 45Project 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 riskWhich project has more variability (risk)? Project B is riskierWe 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