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Ch 5 Solutions Rev CF2.feb067 - The Trade-Off between Risk...

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The Trade-Off between Risk and Return 53 Chapter 5: The Trade-Off between Risk and Return Answers to questions 5-1. Discounted cash flow analysis is used by managers to value real investment projects as well as by investors to value financial assets like stocks and bonds. In either case, the valuation process attempts to determine how attractive a particular investment opportunity is relative to some alternative. This requires an assessment of how risky the investment opportunity is, as well as an assessment of what return the investor/manager might expect from an equally risky investment alternative. It is that return on an equally risky alternative investment that becomes the discount rate in the DCF calculation. Therefore, to determine the discount rate in a DCF analysis, we must first determine the riskiness of the asset or investment being valued, and then we must know what kind of return we should expect for assets of that risk level. 5-2. In all countries, investments that appear to be riskier offer higher returns. The tradeoff investors face is that to earn higher returns, they must be willing to accept more risk. 5-3. Investors are more concerned with real returns because they want to ensure that their purchasing power at least remains the same, and preferably increases. 5-4. After the price declines, the expected return rises. There is an inverse relationship between return and price. 5-5. Risk premium refers to the amount of reward investors demand above the risk free rate in order to invest in risky assets. If riskier assets did not offer a premium risk-averse investors would not invest in them. 5-6. Surveys indicate that financial experts expect the U.S. equity risk premium (relative to bills) to be between four and seven percent in the long run. Table 5.2 shows that over roughly the last century, the risk premium on stocks versus bills averaged 7.5 percent. This is roughly in the middle of the pack of the countries reported in Table 5.2. 5-7. In the long-run stocks return more than other investments. If an investor can hold on to stocks for a long enough time, eventually they will earn a fair return for the risk. The problem is that sometimes investors need money from their stocks in a down market and can’t wait for their portfolio values to recover. 5-8. A risk averse person, given the choice between two investments with the same return will always chose the investment with the least risk. Similarly, given the choice of two investments with the same return, a risk averse investor will always choose the investment with the least risk. A risk- neutral investor will invest in risky securities even if they offer only a small risk premium. 5-9. Historically we see that riskier investments pay higher average returns. This is consistent with the notion that riskier investments MUST offer higher returns to entice risk-averse investors to buy them. If investors were not risk averse, then we should not expect to see riskier investments paying higher returns on average.
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