Lecture 4 - Lecture4 Inthischapter,,risk,.We ,,...

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Lecture 4 In this chapter, we will look at one of the most important components, risk, in pricing financial assets.  We  will look at what risk is, how risk is measured in a financial analysis, and how risk affects the rate of return  of a financial asset.  Investment Returns There are two ways that one can express an investment returns. 1. Dollar return Dollar return = amount received – amount invested - easy to express - two problems are associated with dollar return: scale problem and timing problem 2. Rate of return (Percentage return) RR = (Amount received – amount invested)/amount invested - rate of return standardizes the return -> size problem is no longer a problem - timing problem can be solved by expressing rate of return on an annual basis Defining and Measuring Risk In general, risk is associated with the chance that some unfavorable even will occur.  However, in finance,  usually we look at the deviations from the expected return as risk.  This means that risk includes not only  the possible loss but also possible gain.   Risk  – the chance that an outcome other than expected will occur (or the variability in the investment’s  return).   Stand-alone risk  – the risk associated with an investment when it is held by itself, or in isolation.   Portfolio risk  – the risk associated with an investment when it is held in combination with other assets.   The return expected from an investment is positively related to the investment risk – a higher expected  return represents an investor’s compensation for taking on greater risk. We shall see this later. Interest rate risk  – risks associated with changes in interest rates Reinvestment rate risk  – the risk associated with reinvesting earnings on principal at a lower rate than  was initially earned.  Purchasing power risk  – uncertainty that future inflation will erode the purchasing power of assets and  income Exchange rate risk  – risk of loss from changes in the value of foreign currencies Probability distribution  – a listing of all possible outcomes, or events, with a probability assigned to each  outcome.  For example, probabilities can be assigned to the possible outcomes from an investment.   Outcomes Probability Bad (-5% return) .20 Normal(6% return) .60 Good(15% return) .20 1.00 Notice that the probabilities must sum to 1.00 to account for all the possible outcomes.  Expected Rate of Return An expected rate of return from an investment can be calculated from the probability distribution  associated with it.  The expected return on the example above is 5.6% (.20(-5%) + .60(6%) + .20(15%)). 
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