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Topic4RiskReturn - TOPIC 4 Risk and Returns The Objective...

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TOPIC 4 Risk and Returns The Objective of this chapter is to help us to understand the principle: Axiom 1: The Risk-Return Tradeoff - Axiom 1: The Risk-Return Tradeoff - Investor Won’t Take on Additional Risk Investor Won’t Take on Additional Risk Unless They Expect to be Unless They Expect to be Compensated with Additional return. Compensated with Additional return.
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Important Guidelines: 1. The expected benefits or returns that an investment generates is measured in the form of cash flows and not accounting profits. Axiom 3: Cash - Not Profit - Is King. Thus, the riskiness of the investment is measured in term of the riskiness of its cash flows.
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Consider the 2 possible investments: 1. Consider investing in a risk-free government security with an annual return of 6% matures in 90 days, against 2. Investing in a company which has the following estimate annual returns:
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Expected Return kˆ = P1k1 + P2k2………Pnkn = .10(0%)+.20(5%)+.40(15%)+.20(25%) +.10(30%) = 15%
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Determine kˆ
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What is Risk? “Risk is the potential variability in future cash flows - the wider the range of possible events that can occur, the greater the risk.”
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What is Risk? “Risk is the potential variability in future cash flows - the wider the range of possible events that can occur, the greater the risk.”
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“The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be closed to the expected outcome, and, consequently, the less likely is that the actual return will end up far below the expected return, Thus, the tighter the probability distribution, the lower the risk assigned to a stock”. Pg.. 149
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2.Riskiness of an assets can be measured in either as (a) STAND-ALONE BASIS, or (2) in a PORTFOLIO CONTEXT.
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