Corporate Finance page 4

Corporate Finance page 4 - Risk premium represents the...

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- - Risk premium represents the additional return that investors expect to earn to compensate them for the security’s risk. When a cash flow is risky, to compute its present value we must discount the cash flow we expect on average at a rate that equals the risk-free interest rate plus an appropriate risk premium. - The risk of a security must be calculated in relation to the fluctuations of other investments in the economy. A security’s risk premium will be higher the more its returns tend to vary with the overall economy and the market index. If the security’s returns vary in the opposite direction of the market index, it offers insurance and will have a negative risk premium. - Rate of return s = risk-free rate + risk premium for investment s - Transaction costs (in the market): when you pay a higher price while buying a security (ask) than what you receive when you sell (bid). This is the bid-ask spread. Chapter 5
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Corporate Finance page 4 - Risk premium represents the...

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