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FIN504_PowerPoint_Slides_12

FIN504_PowerPoint_Slides_12 - FIN 504 Financial Management...

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FIN 504: Financial Management Lecture 12: Risk versus Return
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2 FIN 504: Financial Management Topics What is Risk? Three Stage Analysis of Risk Two Classes of Risk Diversification Standard Deviation and Variance as Risk Measures
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What is Risk?
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4 FIN 504: Financial Management Risk and Uncertainty In every facet of our lives we face something unknown. When this lack of knowledge is complete, it is often called ‘uncertainty’. In many cases, however, we may not know what is going to happen, but we have some idea of its probability, and this we call ‘risk’.
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5 FIN 504: Financial Management Risk and Uncertainty While abstract, the distinction is important, because only in the case of risk can we form rational expectations. If you ask me to put my hand in a box and pull out a mystery object, this is uncertainty, since I have no idea what the box may contain. If you ask me to put my hand in a box containing an equal number of red and blue balls and ask me to pull out a ball, this is risk, since I may not know which color I will get, but I know that the probability is 50-50 for each color.
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6 FIN 504: Financial Management Risk In finance, we only deal with risk, because only risk can be quantified. This is why you have been required to study statistics! Statistics is our technique for quantifying risk.
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7 FIN 504: Financial Management Risk There are two aspects to this quantification: First, this quantification is based on past data, normally the historical prices of an asset. Note this assumes that the future behavior will be like the past behavior. Second, this quantification is accomplished by describing that data’s statistical characteristics, e.g., distribution, mean, variance, etc.
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8 FIN 504: Financial Management Risk For example, I could analyze some historical financial data by determining: It is normally distributed. The mean is 10. The standard deviation is 25%. From this I could forecast the future behavior of an asset.
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9 FIN 504: Financial Management Risk But this forecast would only be an expectation, and the realized/actual value could easily differ from my expected value. I could also quantify the forecast error (Remember confidence intervals). Note that in cases of uncertainty I could not even form such an expectation.
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10 FIN 504: Financial Management What is Risk Risk is the possibility that the realized value will differ from the expected value . If an asset is risk free than I know that the realized value will be the expected value. Greater risk is associated with greater likelihood that the realized value will differ from the expected value.
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11 FIN 504: Financial Management Downside versus Upside Risk The realized value may either be higher or lower than the expected value.
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