02 L2 - Lesson 2: Overview When you complete Lesson 2, you...

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Lesson 2: Overview When you complete Lesson 2, you will be able to discuss: 1. Market rates of interest and the issue of risk and return 2. The yield curve, 3. Defining and measuring risk, 4. Probability distributions and expected rates of return, 5. Risk analysis, 6. Assets held in isolation, 7. Market risk analysis, 8. Assets held in portfolios, 9. Efficient portfolios, and 10. Choosing an optimal portfolio An Overview of Risk and Reward Neither individuals acting on their own behalf nor managers acting for their firms' shareholders should make investment decisions solely on the basis of expected returns - they should assess the riskiness of each investment and then ask whether the expected return is sufficient to compensate for the investment's risk. Risk and Reward 1. Stand-alone risk 2. Portfolio risk 3. Efficient Portfolios Risk is related to the probability of earning a return less than the expected return, and the greater the chance of low or negative returns, the riskier the investment. The next topic is Market Rates of Interest: Yield Curves .
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Market Rates of Interest: Yield Curve Investors make decisions about risk and return by assessing risk relative to a "risk-free" yield. The "risk-free" yield is usually taken to be based on US Treasury securities. Market Rates of Interest 1. US Treasury Bills 2. US Treasury Bonds 3. Yield Curve Question Why is the T-bill return independent of the economy? Answer The T-bill will return the promised 5%, regardless of the economy. Question Do T-bills promise a completely risk-free return? Answer NO. T-bills do not promise a completely risk-free return. T-bills are still exposed to the risk of inflation. However, not much unexpected inflation is likely to occur over a relatively short period. In the current period, the US Treasury Yield Curve defines the "risk-free" yield at various maturities. The next topic is Defining and Measuring Risk .
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Defining and Measuring Risk We have reviewed risk in previous lessons, but you should always ask yourself, "How much return is required to compensate for a given degree of risk?" Question What exactly is investment risk? Answer Investment risk pertains to the probability of realized returns being less than expected return. The greater the chance of low or negative returns the riskier the investment. Remember: Risk is defined in Webster's as "a hazard; a peril; exposure to loss or injury." The next topic is Probability Distribution and Expected Rates of Return .
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A probability distribution is defined as a set of possible outcomes, with a probability of occurrence attached to each outcome. Probability Distributions Firms can have the same expected return but the variance of that return is a measure of the riskiness of obtaining that return. The next topic is
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02 L2 - Lesson 2: Overview When you complete Lesson 2, you...

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